Governance tokens: What are they, why are they necessary and how are they used?

Governance tokens are digital assets that give their owners the right to participate in decision-making that affects the functioning and development of blockchain projects. Issues at stake can include the development of new products and features, budget spending, integrating or partnering with other crypto projects, and much more. This means that governance token holders have the right to vote on the adoption of a given decision and put forward their own initiatives. In most cases, one token is equal to one vote.

Governance tokens are a subset of utility tokens, so they can have other functions besides voting.

Utility tokens are tokens that are issued to support the development and financing of crypto projects and reflect some form of value within project ecosystems such as reputation, points awarded for carrying out certain actions, or in-game currencies.

Decentralized autonomous organizations (DAOs) usually serve as the organizational basis for project governance systems using governance tokens.

A DAO is an organization that coordinates interactions between its members using smart contracts.

Why are governance tokens needed and which blockchain projects use them?

Many DApps and, in the case of DeFi, entire financial ecosystems are built using blockchain technology. In many cases, the applications themselves are decentralized, but grew out of a centralized organizational structure, which is contrary to the nature of the blockchain and cryptocurrencies. The DAO was therefore developed as a model for the decentralized management of blockchain projects.

The architecture of decentralized autonomous organizations has given crypto project communities the tools needed to take decisions on a number of issues concerning changes to blockchain projects. A governance token serves as the gateway to participation in a DAO, as well as the key economic driver for crypto communities and an incentive to reward their most active participants. This kind of decentralized governance model allows crypto projects to be developed effectively and achieve community consensus.

A governance token in a decentralized protocol can be compared to voting shares in a company, but with direct control.

Pros and cons of governance tokens

The key advantages of governance tokens are as follows:

  • With decentralized management, where the right to vote is conferred upon a wide range of people, the interests of both the organization and users are taken into account;
  • They have the capacity to create loyal and active communities, as each governance token holder is motivated to vote and improve the project. Additionally, governance token holders can put their own proposals forward for voting. Information about the voting process and its results is public, which reduces the risk of fraud.

This system creates the conditions for people to take useful and fair decisions on the development of crypto projects.

As for the disadvantages of governance tokens, the biggest problem of this special asset class is the so-called ‘whale problem’.

Whales are crypto users who own a large percentage of the total supply of a given cryptocurrency.

The problem arises when a few large whales, who own a significant portion of the governance tokens for a particular crypto project, are able to exert an outsized influence on the voting process. This shifts blockchain projects away from decentralization and towards centralized management.

The second downside is that, even with a uniform and fair distribution of governance tokens, it is impossible to guarantee that the decisions made by the majority will benefit the crypto project.

How to acquire governance tokens

The most popular way of acquiring governance tokens is via airdrops. This is when a token issuer sends a certain number of tokens to users based on specific criteria.

For example, Uniswap issues UNI tokens to anybody who exchanged crypto or acted as a liquidity provider before a certain date.

Governance tokens then end up on trading platforms, where anybody can buy them in the same way as standard cryptocurrencies.

Owning a governance token offers an excellent opportunity to participate in the journey of a blockchain project you’re interested in and change it for the better.