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Governance Tokens: What Are They and Why Are They Valuable?

December 6, 2022

Governance Tokens

Web3 and the cryptocurrency industry are built around tokens. Tokens are divided into two types: fungible tokens and non-fungible tokens (also known as NFTs). These tokens can be used for a variety of purposes. Security, utility, and governance tokens are examples of alternative token types.

Platform, security, utility, and governance tokens are examples of alternative token types. Governance tokens are critical for decentralizing the internet, which is a key component of Web3. As a result, in this article, we will take a closer look at these tokens and answer the following questions: What are governance tokens? And what makes them valuable?

DAOs are a closely related concept that is related to governance tokens. DAO is an abbreviation for “decentralized autonomous organization,” which is frequently used to refer to the governance body of a project or dApp (decentralized application). We’ll also devote a section of this post to explaining DAOs, which are closely related concepts.

What are Governance Tokens?

The term “governance tokens” is self-explanatory. Tokens that provide holders with governance privileges within a certain protocol, game, dApp, or DeFi (decentralized finance) solution are what it is all about. But what does this actually imply in practice?

Traditional organizations are often centralized, with individual CEOs or a board of executives dictating the company’s future. This implies that authority is placed on one or a group of people who have the last word in all decisions. This is a classic, efficient structure. On the other hand, individual investors, users, and other stakeholders have no way of influencing future decisions.

Power may be distributed among token holders in Web3 thanks to smart contracts and tokens. As a result, anybody holding a governance token gains authority and the ability to make proposals and participate in decision-making.

Although token holders have voting power, this authority can be distributed in a variety of ways. The most basic structure is that one token equals one vote. This, however, exposes the system to risk since wealthy investors might use their huge funds to guarantee that a project goes in the desired direction on its own.

To prevent issues like this, projects might implement other methods and consider other variables. For example, in some cases, the time a token is held grants it higher voting power. The early adopters who have believed in the project for a longer period of time have additional influence and incentives.

So, now that we have a better grasp of governance tokens, another issue remains: “What do token holders vote on?” In the following section, we’ll look at some basic examples to answer this question.

What Are DAOs?

Even if the technicalities around the practices of governing protocols, dApps, games, or DeFi platforms might vary, the overall structure stays the same. When a project first launches, it creates a number of governance tokens that individuals or groups may purchase on the open market. People who purchase these tokens from a DAO, or decentralized autonomous organization.

A DAO is the governing body of a certain project or protocol. In turn, the organizations frequently operate using Ethereum smart contracts, which allow token holders to engage in the network and freely vote on matters essential to the projects’ future.

Furthermore, because this is on-chain governance, anybody with a device and tokens may participate. As a result, it makes no difference where they are in the world. This implies that a DAO replaces traditional forms of governance and provides a mechanism for Web3 to decentralize decision-making.

Why Are Governance Tokens Valuable?

The primary value of governance tokens is that they provide governing power to those who hold them. Furthermore, having the ability to contribute to a project by voting on major decisions that will influence its future brings people together and encourages collaboration.

The primary value of governance tokens is that they give governing power to individuals who hold them. Furthermore, being able to contribute to a project by voting on important decisions that will shape its future brings a community together and encourages collaboration.

Authority is shared with stakeholders via governance tokens, which is sometimes referred to as “on-chain governance.” Individuals in this system can vote on various proposals, ranging from minor details to more major adjustments to the governance system itself.

The number of proposals is huge, frequently exceeding the number of token holders. This implies that token holders should evaluate a large number of ideas. Some general examples include changes to the ecosystem of a cryptocurrency to integrate more advanced technology to boost security, interest rates in a DeFi protocol, or the game mechanics of a video game.

Governance tokens can also act as utility tokens. And utility token holders can use their holdings to access services or products the protocol provides or exercise their voting rights. “Utility” for governance token holders includes the ability to influence the future direction of a protocol. Compound and Uniswap are two current examples of governance tokens.

Governance Token Examples

There are several governance tokens on the market, and it would be hard to discuss them all in one article. As a result, we’ll delve deeper into three governance tokens from some of the crypto industry’s most important protocols.

We’ll look closely at Maker’s Maker (MKR), Uniswap’s UNI, and Aave’s AAVE.

Maker (MKR), a token used in MakerDAO, is the first example of a governance token. MakerDAO is the world’s largest Web3 lending platform and one of the most powerful DeFi platforms. MKR holders can vote on issues such as changing the platform’s economic regulations.

The UNI governance token is used by the Uniswap protocol. Furthermore, Uniswap is one of the Ethereum network’s major DEXs (decentralized exchanges). Therefore, UNI holders may propose and vote on the platform’s future. However, the blockchain developers still have control over how Uniswap progresses, making it more centralized than other protocols.

AAVE token holders are the ones who take the protocol’s risk and contribute to it in more practical ways. As a result, they have a strong interest in the protocol’s performance, safety, and functionality. This implies that AAVE holders have the ability to vote on issues concerning the AAVE platform, which is important in the Web3 sphere when it comes to lending and borrowing.

What are Governance Tokens? – Summary

Tokens are one of the most crucial features of the crypto world, and there are several types. One of the most crucial is governance tokens, which allow for more decentralization. They also allow the democratization of Web3 protocols, platforms, dApps, and games.

When a Web3 project is launched, governance tokens typically sell out. Furthermore, in return for tokens, buyers contribute to liquidity, which forms the basis of a protocol’s treasury. Whenever the protocol needs to implement changes, they use these funds. 

Token holders generally form a DAO in which suggestions are made in the form of proposals, which the token holders then vote on. Furthermore, one token equals one vote on issues in their most basic form. This is not always the case; for example, the duration of time someone holds a token may impact their voting power.

Written by Tauseef Azhar

October 10, 2022

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