What Is a Governance Token?

Governance tokens are an incredibly important part of the crypto ecosystem, and are set to become more prominent as things evolve and mature. Here, we explain exactly how they work.

When we hear “governance” we typically think of a top-down approach, kind of like a government or a corporate entity. Someone is leading the structure and people follow the instructions. It’s the traditional approach to governing a body or collective and it’s kind of what we’re used to.

With traditional governance, that’s usually quite accurate. There’s typically a pyramid of power and those overseeing have control over what happens. Below the decision-makers, there is a team to execute new developments. However, decentralized blockchains opened the door to a new mechanism: On-chain governance.

To explain, since blockchains can execute transactions without a centralized entity, it means you can propose and vote on decisions without the need for a middle-man to tally up the scores. But instead of votes, on-chain governance allows communities to coordinate changes on the blockchain network using tokens. To clarify, some blockchains are able to support tokens vs native coins which all blockchains use. These are digital assets that operate without a chain of their own, instead using a host blockchain to issue and manage tokens. This makes them interoperable with one another, but it also makes them very easy to set up-especially for the purposes of managing decentralized communities.

Tokens used for this specific purpose are called governance tokens. But what is a governance token exactly?

What Is a Governance Token?

Simply put, governance tokens are crypto tokens tied to a specific smart contract that grant the owner voting powers over on-chain decisions. They’re like a little voting chip issued to members involved in the project to accept or reject proposed changes. This means that anyone with a governance token has the power to choose the future of a specific protocol. Every token offers the owner a voice in the ecosystem. This ensures that devs, big wigs and big miners don’t make the decisions in siloes.

What Is a Governance Token For?

The beauty in a governance token is that it allows projects to become fully decentralized and autonomous, forming and galvanizing a community by distributing control to the users in an organized way. In this model, hierarchy is suddenly defunct. 

This has already created ripples in how we organize and what we expect from digital communities. The emerging ecosystem of DAOs is purely thanks to governance tokens. In short, these powerful tokens allow holders to form a real community and have their voice heard. All sorts of DAOs, from creative projects to automated market maker (AMM) DAOs, investment DAOs, and decentralized metaverses, rely on governance tokens to operate. These tokens empower the community to run the project and dictate its future. 

Examples of Top Governance Tokens

To get a better picture of exactly what sort of projects are utilizing governance tokens, and how, let’s take a look at some recent examples of them in action.

Yearn. Finance ($YFI)

Decentralization exists on a spectrum, and it makes sense to begin with the project pushing the limits of that spectrum. To explain, YFI is the token behind Yearn.finance, a project that was launched by a guy called Andre Cronje. His decision as the lead dev of the project was to create a token that would hand over the reins of the project entirely to the community. In doing so, it would become a self-sufficient DAO. In other words, Kronje himself did not keep any of the token, or its associated powers.

The launch of the project was a big deal and it’s considered one of the deepest dives into decentralization we’ve seen so far. In fact, it was a bit of an experiment in the space. It pushed the boundaries of how extreme decentralization could go.

Polkadot (DOT)

Unfortunately, governing a blockchain comes with many of the same problems as real-life governments. One common bone of contention is low voter turn-out, which can make processes slow and unrepresentative. Polkadot – the layer-two blockchain seeking to make all networks interoperable – overcomes this with a formalized system. In this case, Council Members are elected by holders of DOT, sort of like members of parliament. Put simply, Polkadot’s on-chain governance gave careful consideration to how its voting processes would interact with the people behind the tokens.

Ethereum Name Service

One interesting trend to emerge from the use of governance tokens is incentivization of support for early-stage projects. Ethereum Name Service (ENS) adopters saw a MASSIVE reward with a huge airdrop of governance tokens in late 2020. Naturally, it caused a major stir in the space. The price of the project’s native token ($ENS) shot up and the early adopters saw an immediate reward for their initial support.

The drop came with a bit of a caveat though. To claim the tokens, users needed to vote on four of the articles of the protocol’s constitution first. It’s a case of active participation generating active rewards – representing the concept of governance token rather neatly.

Decentraland DAO

The metaverse promises to offer users hyper-realistic online societies that mimic real life. But infact it offers greater potential for global collaboration, creativity and global self-governance. So it stands to reason that governance tokens are playing a big role in organizing the voices within that system. 

Decentraland, one of the biggest social metaverses in the space operates using a DAO; with voting taking place using its native tokens MANA. This ERC-20 token is used to vote on decisions and proposals about the Decentraland ecosystem and its future. For example, some of the past proposals included; listing certain locations as points of interest, electing DAO facilitators, banning addresses from certain features and a whole lot more.

All of this operates smoothly via a community that is physically scattered but united around the management of Decentraland.

How To Get Governance Tokens

There’s little room for doubt that these tokens will change our expectations. Instead of simply wanting financial rewards from the projects we’ve bought into, users are coming to expect their loyalty to be rewarded with a stake in the project’s future. 

As we’ve learned (ENS we’re lookin’ at you), we can’t always predict when a project will launch its own governance token. But there are a few places you can look to gain a little insight about a project’s future plans. This means looking at the project’s roadmap and chatting with active members of the project’s Discord community. In fact, it’s also a smart idea to read the project’s white paper and have a look at its token details on EtherScan too. It takes a little bit of technical digging, but can often yield some good alpha about if there’s a drop coming in the future.

What are The Risks of Governance Tokens?

The distribution of power via governance tokens means that the fate of a project rests in the hands of its community.

Read that again. Yes, it is a bit scary. And that’s OK.

These tokens are not just about power – they confer a pretty big responsibility too. How a project performs relates directly to how it governs its community. With decentralized governance still nascent, we’re yet to see where that will take the blockchain environment as a whole. But with DAOs emerging to rival traditional companies in nearly every sector, the metaverse on the ascent. What’s more, DeFi continues to offer users fairer access to finance via decentralized protocols. Seemingly, this is the start of something pretty significant, not just in terms of technology, but in terms of how we consider communities to exist.

So stay informed. Talk to the projects that interest you and make sure you do you own research. The reward is having a voice where you never had one before.

Knowledge is Power.

Interested in governance structures? You should be! They’re changing everything, and could benefit you. Here, School of Block explains DAOs. Enjoy!