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What are governance tokens?

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Looking at several existing traditional organizations, it is observed that the management responsibilities rest on the shoulders of some individuals or, better say, a board of directors, who ensure that such companies are well-governed. What are governance tokens?

In a more specific term, this could be described as centralized governance or centralization, which is precisely a setup that concentrates the power of making decisions on a few individuals (around ten people) at the highest level of the organizational structure. This implies that huge power is given to them to influence how the companies will be run. Besides, the board members are positioned to nominate any key executives or terminate their appointments, choose the projects that are worth the company’s investments, and decide which strategy is suitable.

That being said, there is a new system that operates differently from the way traditional companies are being run. The emergence of governance tokens reveals the credibility of how organizations can be governed in a different way.
You may have heard of decentralized finance (DeFi) and decentralized autonomous organizations (DAOs).

These are emerging financial technologies that give room for governance tokens, promoting a method of administration that is transparent, decentralized, and equitable. As a matter of fact, tokens are made to unite the existing communities for the healthy development of the blockchain projects.

What are governance tokens?

It’s no longer news that blockchain is purely a decentralized system and every project within the world is usually in the quest to give enormous responsibility and power to users. To facilitate the feasibility of this operation, there is a need to bring in a method that guarantees that only seriously committed users participate.

For an indisputable achievement, there is a need for the creation of a specific organization type that can be managed collectively, which is referred to as a decentralized autonomous organization. It doesn’t end there. There will also be a need for participants who are prepared to invest their funds to get voting powers in return.

Most times, this setup is designed to ensure that the voting power of individuals with more financial investments exceeds that of those with lower financial investments. In the DAO, therefore, to represent an individual’s stake, users are provided with a governance token, which is a utility token type.

What then are these governance tokens? Governance tokens refer to tokens created by developers purposely to ensure that token holders are provided with the opportunity to assist in transforming the future of a specific protocol.

As a holder of crypto tokens, you have a say on the project – you can share your views or make decisions on new feature proposals and even make changes to the governance system. When control is shared among coin holders, this activity is referred to as “on-chain governance.”

Maker (MKR) is an excellent example of a crypto token. It’s a token that ensures that stakeholders can vote on decisions related to the DeFi (decentralized finance) protocol, which is the power source of the decentralized stablecoin DAI. Furthermore, holders of MKR can influence the rigid economic rules set for decentralized lending that allows the stable price of the DAI.

Since the part that coin holders play is so important, there is a need to ensure that they are interested in the project’s success for a very long time. To do this, a share of network transaction fees is usually channeled by protocols into the token holders’ wallets. You should note that the tokens may feature non-governance rights– a good example is a right that makes exchanging the coins at predefined rates for other tokens possible.

Let’s take Luna as a case study. It’s a governance token used by the Terra network. Like other regular digital currencies, luna is traded on virtual exchanges; however, it’s designed with some functions so stakeholders can join in making decisions on its network policy. In 2021, a huge amount of luna tokens were burnt, and millions of new TerraUSD stablecoins were minted. This could be traced to the luna holders’ vote. The holders of the tokens later debated the perks and the drawbacks of such a decision.

Due to the powers given to the token holders by the governance tokens, the tokens are able to get some values. This positively affects their sizable valuations– at the end of 2021 trading, luna was able to mount over $80.
DAOs use crypto tokens to structure how decisions are made. The organizations ensure that central management is avoided by giving the power to the stakeholders.

How do governance tokens work?

The main way to ensure the realization of distributed control in projects such as DeFi, DAO, and DApp (Decentralized application) is through governance tokens. These tokens are usually given to holders based on how they contribute and remain loyal to the community. And these active users have the privilege to vote on key issues, ensuring the success of the projects. The results of the holders’ vote are implemented automatically because it is done through smart contracts.

Previously we talked about the MakerDAO, which is one of the first governance tokens. Holders of MKR are in charge of governing the Maker Protocol. Also, an MKR token and a vote have the same value, and there is an adoption of the decision that has the highest votes. As a token holder, you can vote on several issues, including the adoption of new rules, adjustments of fees, and the appointment of team members. Above all, the goal that is striven for is the efficiency, transparency, and stability of MakerDao’s stablecoin.

“Compound” is another excellent example of a crypto token. It’s a decentralized finance protocol that gives asset holders the opportunity to borrow and lend digital currencies. The governance token provided is “COMP,” which gives the users the power to vote on salient decisions. As a user, your on-chain activity will determine the number of tokens that will be allocated to you. This implies that you get more COMP tokens as you borrow or lend more on Compound.

Like MakerDAO, a COMP token and a vote have the same value. As a user, you can delegate your tokens to someone else for them to vote for you. You should note that in 2020, the control of the network’s admin key was relinquished by Compound, meaning that crypto holders were given the power to govern the project with no substitute governance methods.

Apart from the mentioned crypto tokens, other popular ones are those offered by Web3 NFT community ApeCoin DAO, decentralized exchange Uniswap and PancakeSwap, virtual world platform Decentraland, and DeFi lending platform Aave.

For every project, there are peculiar rules that center on the way their crypto tokens work. Stakeholders such as users, investors, and founding teams, get distributed tokens based on the different calculated models. There are governance tokens that vote on most things, while there are others that vote on a specific set of issues. Also, while some governance tokens come with financial dividends, others do not.

Pros and cons of governance tokens

One of the questions you will be eager to ask is if there are benefits that come with governance tokens. Yes, they have several advantages. To start with centralized governance, which usually features misalignment of interests, governance tokens ensure that this misalignment is duly eliminated. What they do is enable decentralized control, where management power is distributed among stakeholders, resulting in the alignment of both the Interest of the organization and the users.

Another merit of governance tokens is that they are capable of building close, collaborative, and active communities. As an active user, you are automatically qualified to vote and contribute constructively to the success of the project. Due to how a token is usually the same value as a vote, it portrays an equal community where decisions are made fairly. Besides, as a stakeholder, you can come up with a proposal that every other crypto holder can vote on. To facilitate voting systems where cheating is not allowed, everyone will see the details of every vote.

Now that we have dealt with some of the advantages of governance tokens let’s delve into some of their challenges. Yes, they feature some drawbacks. And one of these is referred to as the “whale problem.” If you’re a stakeholder with an enormous percentage of a specific digital currency, you are a whale. So if you as a whale with a significant part of the general supply of the project’s governance token, the voting process could be swung in your favor. This is contrary to the essence of the project, which is to ensure that token ownership is evenly distributed among stakeholders and well decentralized.

Another issue is how there is no guarantee that most decisions will always be in the interest of the project, even if crypto tokens are fairly and broadly shared. The voting systems characterized by a person per vote have been in execution for a long time with a mixed track record. Some case reports even show how holders of crypto tokens vote only for the benefit of the large investors and founding team, with no consideration for the broader community.

What’s next for governance tokens?

Governance tokens are a new development in the world of technology birthed from the digital currency space. They are developed evenly to be used widely in more sectors. When we talk about the Web3 movement, we will be referring to a platform for governance tokens, where they can create an evenly decentralized network. DAOs and DeFi have already adopted the management systems, so it’s a matter of time when other industries, including gaming, would also gain momentum.

The primary objective of crypto tokens is to solve emerging challenges. With the look of things, they have not stopped evolving to ensure this objective is continually achieved. For the whale problem, new mechanisms might be adopted to ensure that it is dealt with, and other methods could be used to improve the voting process. So new ways may develop that would see to the delegation of votes. There is the possibility of the space getting more complex as novel innovations emerge.

The future of crypto tokens is also impacted by another significant factor which is potential regulatory changes. These tokens could be seen as securities by several governments, placing them under strict regulations and influencing their functionality.

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