What are governance tokens: and why are they important?

What is a governance token?

Governance tokens give communities decision-making power, and holders can vote on improvement proposals. Governance tokens also reflect the holder\'s rights in the management of all projects in the community.

Key Points

Governance tokens are issued by cryptocurrencies and mainstream projects that operate decentralized autonomous organizations (DAOs). Holding governance tokens automatically becomes a member of the DAO.

DAO members can vote on project improvement proposals through the governance portal. The portal summarizes votes, and in most cases, the result is the only factor that determines the community\'s next move.

Governance tokens can be designed to be used only to vote on proposals, or they can have additional uses such as incentives and ecosystem financing. Most contemporary governance tokens are tradeable and their market price reflects the value of the government or community they represent.

Popular governance tokens include Maker DAO\'s MAKER (MKR), Uniswap\'s UNI, and Curve DAO\'s CRV.

When smart contracts, decentralized applications, or native blockchain project teams want to democratize and decentralize the decision-making process, they use governance tokens to empower decision-making power to their communities. Community-owned blockchain and cryptocurrency projects are often called decentralized autonomous organizations (DAOs). Most DAOs require tokens to operate, the issuance and granting of obligations for these tokens.

Governance tokens give holders the right to vote on proposed improvements on the DAO governance portal. Governance tokens represent the holder\'s interests in all community projects or government management, and holding DAO governance tokens is the only criterion for voting. In some cases, in addition to holding governance tokens, other criteria can be considered. Ultimately, governance tokens are the gateway to all project management in the community.

How to use governance tokens?

Holding governance tokens is only the first step in participating in DAO governance. Although the processes of different DAOs may vary, the general way it works is as follows.

The DAO defines criteria for its voting system-including eligibility criteria and criteria for general and individual voting validity. For example, if less than 40% of members (or governance tokens in circulation) do not participate in the voting, the DAO can declare the entire voting process invalid. Based on these predefined conditions, the DAO developed a voting platform, which usually consisted of a discussion forum and a snapshot portal.

Some projects also include governance systems in their core code, and the DAO is an intrinsic part of such projects.

Proposals aimed at improving community technology, overall management or marketing are presented, discussed in community forums, and then voted on on the voting portal.

One way the DAO uses governance tokens is to build its governance portal that allows holders to connect to their wallets and vote based on the number of tokens they own. The platform detects the number of tokens in connected wallets automatically or through smart contracts and allows members to sign voting requests from their wallets.

The second situation involves the token locking process, which usually adopts the Ve token model. \"Ve\" is the abbreviation for \"Voter Custody Token\". The system is generally suitable for tokens that have other purposes than voting. In order to participate in the voting, holders of project governance tokens need to lock in their tokens and receive Ve tokens as required. The \"Voter Custody Tokens\" will then be used only for voting. Locked tokens cannot be used until redemption. Some DAOs encourage this behavior by providing Ve token holders with additional Voter-Annualized Returns (APY), such as the example of Pendle.

Alternatively, some DAOs may allow governance token holders to pledge their tokens to a validator (representative) who will vote on proposals on their behalf. Such systems may be susceptible to centralization, but are effective when collective voting systems are needed. For example, Optimism allows holders to choose a representative to vote for them when governance issues are involved.

In any case, once a member approves a vote, the portal will summarize the vote in real time to ensure transparency. The community can learn about the fate of the proposal through the portal. If the proposal passes a community vote, it will be formally implemented; otherwise, the proposal will be discarded or reviewed on a case-by-case basis.

Why is it important to govern tokens?

Decentralization

With governance tokens, the DAO can attempt to implement a truly decentralized management system without requiring major technical changes to the core blockchain (for native blockchains) or its smart contracts or dApps (for smart contract projects). For off-chain DAOs, the governance token and the DAO portal create a separate platform that allows projects to focus on their off-chain management. The DAO can also decide on changes to core technologies, but the technologies remain unchanged until the proposal goes through a community vote.

On-chain DAOs work similarly, but are integrated into core operations of networks or smart contracts.

The decentralization brought by governance tokens lies in the fair distribution and voting procedures of governance tokens. This is also the main reason why most new DAOs distribute governance tokens for free through community airdrops. Through this process, every active member of the community can share the governance results of the project. The voting process is also inclusive and not subject to geographical restrictions. Ideally, governance tokens ensure that every proposal finally implemented is subject to rigorous community review.

Easy community management

The scale of the cryptocurrency community can be very large. Depending on the success of blockchain and cryptocurrency projects, the number of community members may exceed one million. Reaching consensus on this scale on a centralized platform can be time-consuming and even somewhat impossible. This also leaves room for error, manipulation and censorship. For example, consensus reached through social media and community channels such as Telegram and Discord can be manipulated by robots and multiple accounts.

DAO portals and governance tokens largely suppress this situation. Blockchain is immutable and token ownership cannot be manipulated. Members can only exercise voting rights on the tokens they trust and the tokens entrusted to them, and cannot change them. Members can vote according to their own convenience, the project itself requires almost no review, and the voting application handles most of the process. It returns a final and relatively more reliable result. This saves time and resources, especially for large communities.

Economic and Political Value

The value of a crypto asset only reflects the relevance of the projects it is associated with. This is in line with the theory of demand and supply. For utility projects, the value of their native tokens is expected to grow with the popularity of applications. The same goes for governance tokens. The value of governance tokens is closely related to the political landscape they represent. For governance tokens that are both practical tokens, their value also reflects their practicality. For example, governance tokens for DAO projects like Uniswap reflect the relevance the Uniswap exchange has gained over the years, and the DAO\'s influence on relevant decisions.

If the DAO loses its relevance, the governance token is expected to lose its value, too, although this depends on whether the token is used only for voting purposes.

Ecosystem growth

Governance tokens can set the tone for cryptocurrency and blockchain projects as well as mainstream DAOs. An effective DAO has great appeal for investors who want to join the ecosystem and have their voices heard. This is equally attractive for new and existing projects that want to join the ecosystem.

In addition, an active DAO could also mean a profitable governance token, as asset values grow with the relevance of the DAO. This also attracts traders and investors who want to participate in the long term. All in all, it accelerates the growth of the project ecosystem.

Marketing and Motivation

Cryptocurrency projects have witnessed a parabolic increase in the popularity of issuing governance tokens, especially as some tokens are issued to early adopters or loyal users through airdrop programs. Speculation about future issuance of governance tokens has also driven early success for new projects, as enthusiasts try to position themselves as benefiting from community distribution.

Due to some successful cases, governance tokens are gradually becoming an effective marketing strategy for cryptocurrency projects. Many governance tokens are also used to incentivize projects through passive income plans. This can be directly related to the DAO(rewards to pledge Ve tokens) or other aspects of the project (such as revenue farming and pledge rewards).

Governance tokens are important for the reasons mentioned above. But as an investor holding governance tokens, it may bring both benefits and disadvantages.

Advantages of holding governance tokens

Let\'s take a look at some of the benefits of holding governance tokens:

Become an active member of the community

Holding governance tokens will make you a true member of the community and the DAO. It gives you the opportunity to have a say in how the projects you invest in are managed. This is different from projects without such regulations, where the project team is responsible for decisions and the community chooses to either fully support the project or stand by because those decisions affect the project\'s profitability.

Democracy

While you may not have enough governance tokens to make every proposal work in your favor, a well-structured DAO ensures that your votes are valid and that your choices are not blocked by third parties or the project team itself. Governance tokens and DAOs help achieve true decentralized democracy and make you an integral part of it.

Create profits

Many governance tokens can also be traded. They reflect the adoption of the government they represent and any additional utility attached to them. Holding or trading governance tokens on a regular basis can become an important profitable investment, especially if the project is successful. That being said, this article is not financial advice and recommends conducting adequate research before investing in any cryptocurrency project.

Disadvantages of holding governance tokens

Limited utility

Although some projects attempt to add additional use cases to their governance tokens, a considerable number of projects have made it clear that governance tokens are only used to vote on governance portals. In this case, the use of the token is very limited. In some cases, governance tokens are used as incentives, which can lead to unsustainable token issuance.

Governance token examples

Governance tokens can be used by DEX, NFT and other decentralized applications, such as MakerDAO, which generates DAI.

Uniswap\'s UNI

Uniswap is a pioneer of AMM and is arguably the largest decentralized exchange on Ethereum and other blockchains. Uniswap was originally released on Ethereum and has been deployed on Layer 2 networks such as Optimism and Arbitrum. Uniswap\'s technology is being adopted by Ethereum and many other decentralized exchanges on EVM-compatible networks.

Uniswap launched UNI tokens and airdropped approximately 15% of the total supply to users who interacted with the platform before September 1, 2020. Uni tokens are used to vote on proposals hosted on the Snapshot Portal. Prior to this, proposals will be posted on the community forum and discussed with the community. According to information from the governance platform, each vote lasts for 48 hours, and a majority vote (yes) means that the proposal is approved. But the proposal must receive more than 25,000 UNI votes to be effective.

MakerDAO\'s MKR

Maker issued DAI, a decentralized stablecoin pegged to the value of the U.S. dollar. DAI operates through over-mortgage lending, and CoinGecko data shows that more than $4.5 billion worth of DAIs have been issued to date. Maker manages project and DAI stablecoin transactions through MakerDAO and uses MKR tokens as governance tokens.

Changes to the Maker protocol or the operation of DAI stablecoins will be voted on, and MKR holders will vote on a 1:1 ratio. Holders must deposit their tokens in the governance portal before voting can be made. A majority vote in favor of a proposal means a vote for it.

PancakeSwap\'s Cake

PancakeSwap is the largest decentralized exchange on the BNB smart chain and has expanded to the Ethereum and Aptos networks. CAKE is the platform\'s practical governance token that powers rewards and financial systems and is also used to vote on PancakeSwap operational changes on the governance portal.

PancakeSwap DAO uses the Ve token model. Cake holders lock in their tokens and receive vCAKE based on the number and duration of locked tokens, which is used to vote on improvement proposals. vCAKE is non-transferable and non-tradable.

ENS(Ethereum Name Service)

ENS is a domain name service on the Ethereum blockchain that converts hexadecimal wallet addresses into readable names. To create its DAO, ENS airdropped ENS tokens to its early adopters in November 2021. ENS DAO uses a voting delegation system. The ENS holder delegates its voting rights to the selected entity, and the principal votes as the principal\'s representative. According to the platform information, the principal can view his entrustment at any time.

Proposals are discussed in the project forum and then hosted on the Snapshot Portal for delegates to vote on. Each representative\'s voting rights are equal to the sum of the ENS voting rights they are entrusted to them. At least 1% of the DAO tokens valid for voting must participate in the voting, and at least 50% of participants must vote in support of the proposal to be approved.

Final thoughts

希望维护去中心化系统的加密货币项目会采用治理代币并开发治理门户来指导其决策过程。这种做法在许多著名案例中都取得了成功，这些项目虽然使用了治理代币，但找到了一种管理社区的方法，并确保每位投资者在项目运营方面都有发言权。

但最大的问题在于治理代币对这些项目的影响，以及 DAO 是否真的有效。治理代币的政治相关性与其蕴含的财务潜力持续存在冲突。近期发展态势表明，加密货币爱好者和投资者蜂拥至治理代币和潜在的 DAO，其唯一目标是通过潜在的空投发行治理代币来获利。除了利润猎人之外，财务状况良好的社区成员也可以从市场上获取任意数量的代币，并影响社区决策，因为他们持有已发行治理代币的相当一部分。