What Are Governance Tokens? Explaining Decentralized Decision-Making

Reaching agreements in centralized institutions is already pretty tough, and cryptocurrency adds a touch of complication to the whole process. Blockchain-based projects pride themselves on decentralization, transparency, and equal accessibility, which is why resorting to traditional top-down leadership structures isn't an option. Web3 programmers need different ways to promote efficient and equitable governance online without reverting to the frameworks favored in the centralized world.

While developers continue to work on innovative programs for decentralized policymaking, governance tokens have become a popular tool in the crypto ecosystem. Let’s explore why so many decentralized protocols issue governance tokens and how they shape crypto's future.

What is a governance token?

Governance tokens are cryptocurrencies that give token holders voting privileges on decentralized protocol decisions. Often, developers behind a decentralized application (dApp) release governance tokens on top of the layer-1 blockchain they're using to support their projects, such as Ethereum (ETH), Cosmos (ATOM), or Solana (SOL).

Like other fungible cryptocurrencies, governance tokens have a market price on the crypto market and trade on centralized and decentralized exchanges—but price speculation isn't the primary purpose behind these crypto assets. The goal is to give dApp users a voice in decision-making and foster equality in the Web3 community.

In addition to voting rights, many governance tokens let users submit proposed changes to a dApp for formal consideration.

How do crypto governance tokens work?

Crypto governance tokens use smart contracts to tally votes and enforce results without third-party intervention. Thanks to their preprogrammed instructions, smart contracts know each election’s outcome and automatically carry out the winning side when the voting window closes.

dApps with governance tokens typically form an online community called a decentralized autonomous organization (DAO), which organizes all the governance proceedings in one election portal. On a DAO's main page, token holders submit petitions, review the latest news, and vote on current proposals. Each dApp has a distinct way of counting votes, but it's common for one governance token to equal one vote for or against a proposed policy change. Typically, dApp users stake the number of governance tokens they want in a smart contract-based proposal and wait for the final results.

After the voting window closes, the smart contract records the results on the blockchain's payment ledger and returns the governance tokens to each user's crypto wallet.

Governance tokens vs. utility tokens: What's the difference?

Utility tokens are a branch of cryptocurrencies that emphasize their non-monetary use cases within their respective Web3 ecosystems. Since governance tokens have a clear, non-transactional purpose on blockchains (i.e., voting on proposed changes), they fall under the utility token umbrella. However, many other cryptocurrencies don't carry special voting privileges and still fit the utility token category.

For example, cryptocurrency Smooth Love Potion (SLP) is a utility token that serves as a reward and in-game currency for Pokémon-style blockchain game Axie Infinity. So although on-chain voting is a valid use case for utility tokens, plenty of other features give cryptocurrencies "utility."

Pros and cons of governance tokens

Governance tokens are the go-to tools for making decentralized decisions, especially on decentralized finance (DeFi) applications. While these tokens are widely used across Web3, a few potential drawbacks exist.

Governance token pros

Empowers a dApp's user base: Governance tokens strengthen the sense of community on a dApp by giving everyone a direct say in the decision-making process. Since everyone with governance tokens has equal rights to write proposals and vote, there's no sense of discrimination or preferential treatment.
Enhanced adaptability to current demands: Because governance tokens give users the power to propose changes and vote on updates, they provide crucial insights to developers on their dApp's most pressing issues. Token holders may also influence their protocol’s evolution by responding to market demands and emerging trends in the crypto sector. This superior adaptability ensures dApps remain competitive and responsive to users.
Transparent recording and enforcement: Thanks to smart contracts and distributed payment ledgers on blockchains, there's minimal risk of election tampering and manipulation. All voting data is publicly accessible on the blockchain, and smart contracts immediately handle enforcement. Blockchain networks’ transparency strengthens trust in a dApp's accountability and integrity.

Governance token cons

Centralization concerns: In the one-token-equals-one-vote model, traders with large amounts of a dApp's governance token (aka whales) have greater sway over the protocol's direction. Without more nuanced and equitable ways to measure votes (e.g., assessing each user's time commitment or contributions to the network), taking over decentralized governance procedures is possible for wealthy crypto traders.
Slows down scalability: Waiting for votes on every dApp upgrade—especially minor issues like bug fixes—hampers the development pace. Governance voting procedures make decision-making more democratic, but they also make speedy scalability less likely.
Smart contract code vulnerabilities: dApps don't have to worry about centralized counterparty risks, but they’re vulnerable to hacks or bugs in smart contract code. If the smart contracts behind a dApp's governance tokens or voting mechanisms aren't rock solid, they threaten a dApp's reputation and integrity.

Where to trade governance tokens

When dApps first introduce governance tokens, they sometimes reward them to loyal traders or liquidity providers as free rewards (aka airdrops). Earning governance tokens on DeFi platforms for trading, staking, or participating in liquidity pools is possible, but many of these tokens are available on crypto exchanges.

To find the latest trading pairs for governance tokens, visit a cryptocurrency price aggregator like CoinMarketCap or CoinGecko and type the governance token's name or ticker in the search tab. Once on the official governance token's price page, scroll to the Exchanges tab to see all centralized and decentralized trading platforms offering this cryptocurrency.

Examples of governance tokens

Governance tokens are popular on DeFi dApps, but they aren't exclusive to decentralized exchanges (DEXs) and crypto lending sites. Many protocols outside DeFi have begun experimenting with the benefits governance tokens offer their Web3 communities. Here are a few:

Uniswap (UNI): In 2020, Ethereum-based DEX Uniswap airdropped its governance token UNI to crypto traders who interacted with its spot crypto trading protocol either as a trader or liquidity provider. As one of the largest automated-market maker (AMM) DEXs, UNI token remains one of the most actively traded governance tokens on crypto exchanges.
Aave (AAVE): Crypto lending platform Aave offers users the AAVE governance token to take part in regular votes over protocol upgrades or changes to current collateral requirements and interest fees. AAVE holders can also stake their tokens to Aave's Safety Module to earn crypto rewards in exchange for providing emergency funding.
Maker (MKR): Etheruem's MakerDAO is most famous for issuing the USD stablecoin DAI on its crypto lending and borrowing protocol. MakerDAO community members use the MKR token to vote on issues such as code updates, fee rates, and accepted crypto collateral.
Ethereum Name Service (ENS): Launched in 2017, the ENS is a dApp on Ethereum that helps users create and link human-readable domains to their crypto wallet addresses. To preserve the ENS's decentralization, developers introduced the ENS DAO governance token for submitting proposals and voting on upgrades to its protocol.

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