Tokenization 101: What is a governance token?

Cryptocurrency Mar 1, 2022

Introduction

In the decentralized world of blockchain, the concept of distributing power and responsibility to the users, not the large few, is important. For that to work, a mechanism that guarantees only those who are seriously committed to the success of a project can participate in its governance needs to be in place.

One way to achieve that is known as DAO (decentralized autonomous organization), which requires participants to use a type of utility tokens known as governance tokens to vote.

Governance token

Governance tokens are a type of utility token that represents voting power on a blockchain project. With governance tokens, one can create and vote on governance proposals. Therefore, governance token holders can influence decisions concerning the project such as proposing or deciding on new features or even changing the governance system itself.

Decentralized finance revived the need for a fundamental feature of blockchain, decentralization. To achieve complete decentralization, a project not only relies on smart contracts but also needs to delegate voting powers to the community t as well. For that reason, DAO and governance tokens are growing in popularity populate amid DeFi’s booming.

One of the well-known examples of a governance token is Maker (MKR), the governance token of the DeFi project MakerDAO. This token allows its holders to vote on decisions pertaining to the protocol, such as changing the complex economic rules that govern decentralized lending. It’s also worth noting that MakerDAO protocol has the decentralized stablecoin DAI running on it. Some other well-known governance token examples include COMP (Compound), UNI (Uniswap), LUNA (Terra), etc.

For DeFi projects that adopt DAO governance systems, governance tokens have power over anything that needs implementation, such as changing fees, upgrading UI, changing reward distribution, revising developer funds and more.

Although voting power is the most significant feature of governance tokens, that doesn’t mean they don’t have other features. Governance token holders can also stake, take out loans or earn rewards by simply holding and staking the tokens. Some projects use the utility tokens issued to participate in the project as governance tokens.

Governance tokens vs. utility tokens

Strictly speaking, all governance tokens are utility tokens, but not all utility tokens are governance tokens.

Utility tokens are tokens that have some form of utility, and the utility is commonly related to the crypto platform itself. Golem (GNT), for instance, allows users to participate in the Golem protocol and participate in their network to loan out their computer’s spare processing power to others. However, Golem holders don’t have the power to vote on the future of Golem protocol.

The fundamental difference between the governance and utility tokens is that governance tokens feature governance power. This feature makes governance tokens the representation of true decentralization.

Closing

With their creation, governance tokens gave voting power to the average users instead of only the powerful few. With the governance tokens mechanism, no one feels left behind or without a voice in blockchain projects across sectors like DeFi. Project teams don’t have to make hard choices but instead can interact with the community to find out what is right or wrong for the project, why a specific feature should be changed, and how the team should handle funds and partnerships.

Governance tokens are an important part of the blockchain ecosystem because they are harbingers of complete decentralization. They are not pre-mined, and the decision-making process is limited to those who are invested in the project. The project can only become more successful if those involved are financially incentivized to push the entire project forward.

Read more on Tokenization series.

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