What Is a Governance Token?
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Governance tokens aim to empower their holders by giving them a say in the development and management of decentralized projects. They are integral to the operation of decentralized autonomous organizations (DAOs) and decentralized finance (DeFi) protocols, granting holders voting rights on various proposals. With a current market cap of $24 billion, this growing sector of the crypto ecosystem has captured mainstream interest in recent years.
In this article, we will delve deeper into the workings of governance tokens, exploring how they function, the different types available, and their advantages and drawbacks. We will also examine some of the most prominent governance tokens in the market and compare them with utility tokens. Let’s get into it.
How Do Governance Tokens Work?
Governance tokens function by giving their holders the ability to influence the direction and development of a project. This influence is exerted through voting mechanisms built into the protocol. When a proposal is made, token holders can cast votes proportional to the number of tokens they hold. This ensures that those with a greater stake in the project have a commensurate influence on its future.
Voting with governance tokens typically involves locking up the tokens in a smart contract during the voting period.
For example, in the case of Uniswap, a proposal to change the fee structure or update a protocol feature would be put to a vote, and UNI token holders would lock their tokens in the voting contract to signal their approval or disapproval. The outcome of the vote is then automatically implemented by the protocol’s smart contracts, ensuring that the decision-making process is both transparent and tamper-proof. This recently occurred, with voters opting to overhaul its rewards protocol, which sent the UNI price soaring.
How Do You Vote With Governance Tokens?
Voting with crypto governance tokens generally involves several steps. First, a proposal is submitted to the community for consideration. This proposal might be related to technical upgrades, changes in protocol rules, or even community initiatives. After the proposal is posted, a voting period is initiated during which token holders can cast their votes. Each token typically represents one vote, though some systems might use different mechanisms such as quadratic voting to balance influence.
To vote, token holders need to connect their wallets to the voting platform and choose their preferred option. For example, on the Compound platform, users connect their wallets and allocate their COMP tokens towards the option they support. The results are tallied at the end of the voting period, and if the proposal receives the required level of support, it is executed. This method ensures that governance decisions are made in a decentralized and democratic manner.
Types of Governance Tokens
In the grand scheme of things, governance tokens come in various forms, each serving different purposes within their respective ecosystems. Understanding the different types can help users appreciate their roles and functionalities. Below are some examples of the main types of these tokens, namely:
- Native governance tokens
- Protocol governance tokens
- Staking governance tokens
- DAO governance tokens
Let’s look at each of them individually, and see what they bring to the table and how they differ.
Native Governance Tokens
To start, native governance tokens are integral to the blockchain or protocol they govern. They are often used to make decisions about the network’s development and operational rules. For example, Ether (ETH) on the Ethereum network, to a degree, can be seen as a native governance token when used in conjunction with the Ethereum Improvement Proposals (EIPs). EIPs are a set of drafted ideas that can be proposed to help enhance the Ethereum network.
Protocol Governance Tokens
Next, we have protocol governance tokens, which are specific to decentralized applications (dApps) or protocols and are used to govern aspects of the protocol. Uniswap’s UNI token is a prime example, allowing holders to vote on changes to the Uniswap protocol, such as fee structures or new liquidity pool features.
Staking Governance Tokens
Staking governance tokens combine the benefits of staking (earning rewards) with governance rights. Holders can stake their tokens to earn rewards while also participating in governance. Tezos (XTZ) is a well-known example, where stakers can delegate their voting power to other users or vote on proposals themselves.
DAO Governance Tokens
Decentralized Autonomous Organizations (DAOs) use governance tokens to manage their operations and make collective decisions. DAO tokens allow members to vote on proposals related to the organization’s activities, such as funding decisions or project partnerships. An example is the MolochDAO, where Moloch tokens are used for governance.
Biggest Governance Tokens
Several governance tokens have gained significant traction and market value, becoming influential within their ecosystems and the wider crypto landscape. Listed below are some of the top governance tokens, namely:
- Uniswap (UNI)
- Internet Computer (ICP)
- Maker (MKR)
1. Uniswap (UNI)
Uniswap’s UNI token is one of the most prominent governance tokens, with a current market capitalization of $4.04B. Launched in September 2020, UNI allows holders to vote on key aspects of the Uniswap protocol, including fee structures and liquidity pool incentives. UNI’s introduction was a significant milestone for decentralized exchanges (DEXs), highlighting the importance of community governance. Aside from UNI, here are some of the best decentralized exchanges in 2024.
2. Internet Computer (ICP)
The Internet Computer (ICP) governance token is central to the governance of the Internet Computer blockchain. ICP tokens are used to vote on proposals that affect the network’s operation, such as protocol upgrades and economic adjustments. This token plays a crucial role in maintaining the decentralized nature of the Internet Computer. As of October 4, 2024 , ICP is trading at $8.23, with a market capitalization of $3.88B.
3. Maker (MKR)
Maker’s MKR token is essential for governing the MakerDAO and the DAI stablecoin system. MKR holders vote on various issues, including risk management, collateral types, and system upgrades. The decentralized governance model of MakerDAO has been a benchmark in the DeFi space, demonstrating the effectiveness of community-driven decision-making. As such, this token sits in the top 35 cryptocurrencies, with a value of $1.28B.
Advantages of Governance Tokens
There are several advantages of governance tokens, with a range of benefits that enhance the functionality and appeal of decentralized systems. These include decentralization, incentives, and community engagement.
Community Control and Decentralization
Governance tokens empower communities by giving them control over the protocols they use. This decentralization ensures that no single entity can dominate decision-making, aligning the project’s evolution with the community’s interests. For example, in the MakerDAO ecosystem, MKR holders have the power to influence decisions that directly impact the stability and growth of the DAI stablecoin.
Incentives for Participation
Holding governance tokens often comes with financial incentives. Token holders might receive rewards for participating in votes or staking their tokens. This incentivizes active participation and aligns the interests of token holders with the health of the ecosystem. In the case of Compound, COMP token holders earn additional tokens for participating in on-chain governance, thus encouraging more engagement.
Potential for Value Appreciation
Governance tokens can appreciate in value as the underlying project grows. Successful governance decisions that enhance the project’s utility and adoption can lead to increased demand for the tokens. For instance, the value of UNI has grown significantly since its launch, reflecting the success and expansion of the Uniswap platform.
Drawbacks of Governance Tokens
Despite the above advantages, governance tokens also come with certain drawbacks that can impact their effectiveness and desirability.
Voting Power Imbalance
One of the significant challenges with governance tokens is the potential for voting power imbalances. Wealthier participants can acquire more tokens, thus having disproportionate influence over decisions. This can lead to centralization of power, undermining the decentralized nature of the project. In some cases, this imbalance can skew decisions in favor of larger holders at the expense of smaller participants.
Technical Complexity
Participating in governance requires a certain level of technical knowledge. Users need to understand how to vote, delegate tokens, and interpret proposals. This complexity can be a barrier for less tech-savvy users, limiting broader participation. For instance, navigating the voting process on platforms like Compound can be daunting for newcomers.
Decision-Making Gridlocks
In some cases, decentralized governance can lead to decision-making gridlocks. When the community is divided on important issues, reaching a consensus can be challenging. This can delay critical updates and improvements, potentially hindering the project’s progress. Such gridlocks have been observed in various decentralized autonomous organization ecosystems where contentious proposals struggle to achieve the required level of support.
Governance Tokens vs. Utility Tokens
Although many compare the two, governance tokens and utility tokens serve different purposes within a blockchain ecosystem. Governance tokens grant voting rights and influence over protocol decisions, whereas utility tokens provide access to a network’s services and functionalities. For example, while UNI is used for governance on Uniswap, Ether (ETH) is primarily a utility token used to pay for transactions on the Ethereum network.
Utility tokens often have broader use cases within their respective ecosystems, such as paying transaction fees, accessing premium features, or facilitating peer-to-peer transactions. In contrast, governance tokens are specifically designed to enable decentralized decision-making and ensure that its community members have a say in the project’s future direction.
Are Governance Tokens Valuable?
The value of governance tokens extends beyond their current cumulative market valuation of $24 billion. They embody the principles of decentralization and community participation, crucial for the success of many blockchain projects. While their financial value can fluctuate, their intrinsic value lies in empowering users to shape the direction of the projects they support. The effectiveness of governance tokens depends on active and informed participation from the community, highlighting the importance of engagement and education.
Several of these tokens, including UNI, MKR, and ICP, are currently in the top 50 of all cryptocurrencies across the globe, despite trading a considerable distance away from their record highs.
Conclusion
Governance tokens have become a cornerstone of DeFi and blockchain governance over the years, enabling community-driven decision-making and aligning the interests of users with the project’s success.
While they offer numerous advantages, including decentralization and potential financial rewards, they also come with challenges, such as voting power imbalances and technical complexity. Understanding the nuances of governance tokens is essential for anyone participating and looking to invest in the decentralized ecosystem.
FAQs
Are governance tokens valuable?
Yes, governance tokens are valuable as they grant holders voting rights and influence over a project’s decisions, contributing to the project’s decentralized nature and aligning it with community interests.
Are governance tokens a good investment?
Governance tokens can be a good investment if the underlying project is successful and well-governed. However, their value can be volatile, and potential investors should consider the project’s long-term prospects and community engagement.
What is the biggest governance token?
The biggest governance tokens by market capitalization include Uniswap (UNI), Maker (MKR), and Compound (COMP), each playing a significant role in their respective ecosystems.
References
Eric Huffman 
Ihssan El Medkouri 
Connor Brooke 