What is a governance token and how do they work?

Definition:

A governance token is a cryptocurrency of a blockchain platform that gives the holder the right to vote on proposals that seek to make changes to a protocol.

So, then we are done, I believe! But for those interested, we'll continue for a while.

A governance token is thus used to determine the future of a blockchain project. Most commonly, these tokens are used for DeFi projects, a dApp or a DAO (Decentralized Autonomous Organization).

If you want to vote with a governance token, you can do so with a publicly viewable smart contract via a consensus algorithm . The words associated with governance include stability, transparency and efficiency.

DeFi in particular is moving more and more toward the DAO with a governance token.

Because stakeholders themselves have invested in a project, they will also value their voice more.

Governance tokens have been the engine for DeFi and DAO. They are the prototype of decentralization. Users will be at the center, exactly as it was intended from Bitcoin onward. The middleman is largely eliminated. It looks a lot like a democracy.

Governance tokens can make a platform more successful. With some platforms, you get all kinds of extra benefits, such as services and rewards. Then they are a lot like shares, ownership.

The first DAO

The first DAO was called "The DAO." In terms of originality, these guys were above average. It started in 2016 and was put out of business by a hard fork on Ethereum because of an error in the smart contract, where 1/3rd of the funds could have been stolen. Ethereum Classic emerged from this, which appealed to the immutability of a blockchain.

How does voting work?

To vote you need governance tokens that you can buy or earn. Once you have them in your possession you can go and see where you can then vote.

If you want to vote you will have to start connecting with your wallet , such as MetaMask, and then use your governance tokens contained therein for voting. Once you are in the voting portal you can also make your own proposals through their interface.

If you want to gain access, platforms usually use a forum or a program like Snapshot for DAOs. A governance forum has the list of proposals you can vote on and you record your vote for each proposal. You can choose to vote only on proposals you have an opinion on. Many proposals will be too technical to vote on.

The program Snapshot creates a snapshot of all the votes cast. I do like appropriate names. For example, I know someone named Dick and, well, you get the idea. First all the votes are added up off-chain, then they are verified on-chain, about which more later.

After the vote, decisions are usually implemented via a smart contract . It also happens that the team has to implement these changes or hire someone to do so.

Many protocols also work with developer suggestions. After all, they know best how the technology works. Governance token holders then vote whether they think this is a great idea or whether they don't like it at all. By doing it this way, there is a big brake on the rampant proliferation of smart contracts and a tangle of rules.

A big advantage of this method is that developers get a reality check. Are they sitting there for months brooding and working on a super fat upgrade, no one is waiting for it. By gauging the mood in advance, you avoid this.

Governance token holders can deliberate what they vote in advance, creating more collaboration within a platform. This also has a downside: if a particular partnership has more than 50% of these tokens, they effectively control the protocol.

You can also delegate your vote on many platforms. Often there is a minimum number of tokens you must have before you can vote. What is also common is that you have to wait a period of time before you are allowed to vote.

Why do governance tokens exist?

Governance tokens were created to get more decentralization in platforms. The top down method works fine for many companies, but it is not very democratic.

By introducing these types of tokens, users also have a voice in the design of a platform. After all, the user is the one who brings in value and therefore may well have a say in the platform they help grow.

Since Maker opened their DAO doors, other platforms saw that this worked just fine, and when one sheep crosses the dam, more follow. More and more platforms, especially in the DeFi world, are switching to this democratic model because of the success of Maker DAO.

"Democracy is the worst form of government, to the exclusion of all other forms that have been tried."

Winston Churchill

How are governance tokens created?

A token issue policy is usually listed in a platform's whitepaper. The token can also be added later by adding it via a smart contract on a blockchain like Ethereum and put it up for sale.

What are governance tokens used for?

Some investors buy these tokens simply because they believe they will be worth more later. Usually, however, they are purchased for the use case they were created for.

You use them, of course, to vote on proposals you like. You can also buy them so that the platform acquires liquidity, for which you get rewards in the form of fees paid by other users and additional currency.

You can farm, lend or stake with it, earning all sorts of rewards common on DeFi platforms.

Sometimes these tokens are also provided through an airdrop handed out to users. UniSwap handed out more than a billion worth of coins to users who had used their platform before September 2020. Rarible also handed out many of their governance token RARI. Through an airdrop you raise awareness of your coin, it is often used as a marketing tool.

A platform uses governance tokens to keep cash in the protocol. As users earn new tokens by keeping their money in the platform you create a vicious cycle in favor of the platform, creating more value and making loyal allies earn more and the platform as a whole becomes more valuable. In this way, a platform creates its own demand for their coins and they automatically become more valuable. Thus, loyalty and commitment to a platform are rewarded.

Examples of projects with governance

The number of projects following this strategy is growing by the day. We will mention a few important ones:

Maker DAO, Curve DAO, SushiSwap, Yearn Finance, UniSwap, PancakeSwap, Aave, Apecoin, Decentraland, Compound and Ethereum Name Service.

Web3 is also moving toward governance and the transition to a decentralized Internet.

What should you look for when buying a governance token?

Look at their roadmap, how many are there, how many will be added, when will many be released from investors and the team.
Distribution is usually among stakeholders such as the founders, team, investors and users. Some platforms let governance token holders decide on everything, while others open up only certain proposals to holders.
One danger here is if too many governance tokens are kept with the founders' team. For example, a key employee of SushiSwap sold millions in tokens all at once, causing the price to collapse. He did pay that back later, but the damage was done. Their reputation had suffered considerable damage.
Another danger is when investors repeat the hedge fund trick. It goes like this: you buy enough shares of a company to have a say in what a company will do. You make decisions that are very much in favor of the hedge fund and then sell all your shares and the price collapses or the company goes bankrupt. This can also happen in governance-driven projects.
Often a governance token is not worth much in the beginning of the platform, but as the project becomes more successful, these tokens and their rewards often become worth much more, as you see with many game platforms and DeFi projects. In the beginning it is a form of passive income, afterwards these tokens could become worth a lot as the project catches on and more use cases emerge.
If the tokens are bought back or burned, governance tokens may also become more valuable. If this is in their roadmap it inspires confidence.

What can you vote for with a governance token?

Interface or appearance
Adjust or change the coding of a project itself
Adapting smart contracts
Adjust fees for liquidity, staking, fees and interest rates
Funds for development of the DAO
Roadmap
New features and upgrades
Adjusting the amount of coins
Appointing new developers
Change the governance system itself

On-chain and off-chain governance

On-chain governance means that decentralized decisions take place directly on a proprietary blockchain. This involves hard-coded rules from the protocol being converted into readable output. One problem with this is that if the community becomes divided and disagrees with an outcome a hard fork can occur.

Off-chain governance means that decisions are made in a more relaxed manner. People will poll on social media, conventions and on technical forums like GitHub to see if things are desirable, and only if the community responds overwhelmingly positively, a proposal will be implemented on-chain. In this process, a hard fork is not likely to occur because there are more checks and balances, miners and users can simply sell their coins or move on to another platform if they don't like the new course.

Benefits of governance tokens

Everyone counts
Anyone can make proposals
Those who own tokens share in the success of the platform
Faster development
Collaboration
Developers get input before they start their work
Prevents hard forks
Passive income
Involvement
Loyalty
More power and control for the community
Transparency
Features that are developed are also used
Disabling intermediaries

Disadvantages of governance tokens

Those with many tokens can begin to determine the direction of the platform
Decentralization can end when someone has a majority of these tokens
Because you vote anonymously, you can deflect the responsibility of your voting behavior onto others
A platform can fail because of problematic voting behavior
Those with many tokens can vote in such a way that they earn more, even though this is detrimental to the platform
Technical proposals by developers are often not understood
Labyrinth of proposals, especially with multi governance tokens within a platform
A proposal is approved, but there is a bug in the smart contract of this proposal
Governments can view these tokens as stocks and introduce regulation, influencing their functionality

What is the difference between a governance token, a utility token and a security

What a governance token is you now by know.

A utility token is a digital asset that you mainly use to get access to all kinds of benefits, such as a service or a product. A well-known example of this is Binance Coin (BNB), which gives you a discount on your trading fees, interest if you stake it and priority access to all sorts of things typical of Binance, such as their Launchpad, where newly-listed coins appear.

Security tokens must meet the rules for a security, such as regulation along multiple jurisdictions and protection of the investor through collateral of real world assets such as real estate, equity or expensive works of art. By investing in a security, you become a fractional owner of these collateral assets.

The future of governance tokens

Most governance tokens from a successful project have become more valuable.

It is claimed that governance tokens have no intrinsic value, but you can assert that about a lot of cryptocurrencies . For example, Bitcoin and many other crypto have no intrinsic value, but apparently many people don't think that's a problem at all, the price keeps going up.

As time goes by, the problems, such as of whales having too much influence, will be solved as cleverly as possible.

In the future, governance tokens may become worth more and more as their platform becomes more successful. In DeFi, the amount of liquidity in a platform will be a measure of the value of a governance token.

In other blockchain projects, the presence of a governance token may attract people to such a platform because of the bottom-up approach.

Since blockchain and cryptocurrency are about decentralization, a governance token fits right into this vision.

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