What is a governance token?

Governance tokens allow users who own the token to help shape the future of the protocol. A platform that allows itself to be shaped by its users using the governance token is called a Decentralized Autonomous Organization (DAO). The holders of the governance token can agree on changes within the protocol. The governance token is characteristic of DeFi projects because it gives users rights and control, something that is a basic tenet of the entire crypto revolution.

How does blockchain governance work?

When changes are proposed, people can vote ‘on chain’, via smart contracts. These changes will be applied automatically as soon as the majority is reached. Sometimes the changes will be applied by the team or by third parties.

The basic principle is that users participate and have a say in the system and it is decided in favor of the majority. On most protocols, binding proposals & votes are conducted through the Snapshot platform. Snapshot provides the ability for users of a particular protocol to decide the fate of the protocol via underwritten messages on the blockchain.

Snapshot Blockchain Governance DeFi

What can people vote on?

The changes on which people will be able to vote vary greatly. For example, people will be able to vote on minor adjustments to major collaborations. Below are some examples of possible changes:

  • Change of user interface (UI).
  • How many fees are allocated and to whom?
  • Distribution of development funds (Devfund)
  • Roadmap for products
  • Recruitment of developers

Use case governance tokens

Governance tokens are used not only to vote but also to get yield. This is done by lending out the token, using it as collateral or using it to earn passive income (See yield farming). Nevertheless, the main purpose of governance tokens is to govern the protocol and the amount a user owns will correspond to the weight in making decisions.

Why are governance tokens important?

Because the community can co-decide using the token, “no one” feels unheard. The decisions are made by the people who are invested in the platform. If the project fails, everyone will fail. If the project wins, everyone will win.

Developers are no longer alone and decisions are made in consultation with the community. No modification will not go through the community first, which automatically increases the transparency of the protocol.

Difference between utility tokens and governance tokens

So what’s the difference with a utility token? Utility tokens are tokens that have a utility. This utility is usually limited to its own blockchain or platform. For example, Binance Coin (BNB) is a utility token and will be used to lower fees, choose new tokens and so on. But a utility token will not give you a say in the future of the platform. So with Binance Coin, you will not be able to vote on future decisions concerning the Binance team. So governance tokens are an upgrade from utility. You literally have a say in the future of the platform.

Pros and Cons of governance tokens

Governance tokens have pros, but there’s also risks:

Pros:

  • Putting power not centrally but in the hands of superiors.
  • Governance creates opportunities to work together. This will inevitably lead to new insights.
  • Governance leads to more engagement.
  • Faster development. One goes from changes proposed by developers to an entire community thinking.

Cons:

  • The human ego will sooner or later get in the way of making moral decisions.
  • No one is responsible. Users will always be able to shift the blame to the majority.
  • Manipulation by big stakeholders. When voting, the majority will win, thus the extremely wealthy of the protocol will have more say than the large crowd. There will be a vote in favor of the big owners when it comes down to it.

Conclusion governance tokens

Governance tokens put decentralization into the word DeFi. They are central to the use of many protocols and have since become indispensable in the world of DeFi. Yet this is not without its dangers. Control gives the ability to execute decisions with a majority that may benefit the little few and not the great mass of users.

Some examples of Governance tokens are Curve, SushiSwap & Maker Dao.