Shrimpy helps thousands of crypto investors manage their entire portfolio in one place.

Learn More ➜
7

×

What Are Governance Tokens?

January 5, 2022

6m

Read Time

The last lesson in Shrimpy Academy’s DeFi series covers perhaps the most important one of them all: governance tokens and models.

Decentralized finance revived the need for a fundamental feature of blockchain technology, decentralization. The only way to achieve complete decentralization is not only to rely exclusively on smart contracts but to delegate voting powers to the community as well. As long as the decision-making process is relayed to community members and executed by a developer team, it is safe to say that the project is decentralized.

Governance models are not necessarily a DeFi thing. The original governance model dates back to 2016 when the Decentralized Autonomous Organization (DAO) held an ICO and gathered a total of $120 million in ETH. After only two days, the DAO embedded itself as the largest crowdfunding project in history.

$120 million solely for the right to vote might seem strange, but today’s governance models both have increased complexity and are worth a lot more.

What are Governance Tokens?

Governance tokens are cryptocurrencies that represent voting power on a blockchain project. They represent the main utility token of DeFi protocols since they distribute powers and rights to users via tokens.

Governance discussions on Yearn Finance

With these tokens, one can create and vote on governance proposals. Community members can spend tokens to directly influence the direction and characteristics of a protocol. It is possible to:

  • Vote for different fees
  • Implement UI changes
  • Change fee reward distribution
  • Revise dev fund
  • And much more

Although most DeFi tokens in the market are governance tokens, that does not mean that voting is their only defining feature. Holders of governance tokens can also stake, take out loans, and earn money by yield farming. Nevertheless, their sole and primary purpose is power distribution.

Why do Governance Tokens Matter?

No one feels left behind or without a voice in an ecosystem like DeFi. Developers do not have to make hard choices, and they can interact with the community and find out what is wrong with the project, why a specific feature should be changed, and how the team should handle funds and partnerships.

List of top governance tokens on Coinmarketcap

Governance also enables users to actively bring change to smart contracts. If an anonymous group attacks the project’s ledger, steals funds, or performs any other malicious activity, neither users nor developers are forced to fork to a different network (which was the case with the DAO).

Ultimately, governance tokens matter because they are harbingers of 100% decentralization. Governance tokens are not premined, and the decision-making process is limited only to those who are quite literally invested in a platform. We can think of it as shareholders who reap the benefits of a businesses’ success. The company can only succeed if those involved are financially incentivized to push the entire project forward.

Governance Token vs. Utility Token

Is there a difference between governance tokens and utility tokens? If so, which one is better and why?

We have previously covered governance tokens, so let us quickly dive into utility tokens. The additional context will help us analyze whether one crypto category is better than the other or not.

To explain it briefly, utility tokens are digital assets that have some form of utility. This utility is, most of the time, restricted to the native blockchain network or crypto platform. A great example of a utility token is BNB. The asset is used for various purposes on Binance, including paying for fees, voting on new token listings, and paying tickets as ‘entrance fees’ for features like the Binance Launchpad.

The fundamental difference is that utility tokens feature no governance power. Binance users can indeed vote on token listings, but beyond that, nothing else can be changed. Users cannot use BNB to decide on other more critical features or to cast their vote and decide to change how Binance looks or works.

Governance tokens are an upgraded version of utility tokens. Because of that, they may as well be the better option. As previously mentioned, governance tokens can also be used for other processes, like staking and creating loans, so there is really no reason why one should prefer utility tokens over governance tokens.

Summary: Advantages and Disadvantages

It is more than clear that governance tokens are advantageous. But what are their disadvantages, and how do they affect crypto protocols? Let us quickly summarize the good, the bad, and the ugly.

Advantages:

  • Decentralization. The only way developers can put the ‘De’ in DeFi is with governance tokens. Without them, projects would be barrens of smart contracts over which no one has any control. Decentralization is the main goal digital assets achieve, so why not include it in a tangible way?
  • Collaboration opportunities. Voting opens the door for discussion, and discussion opens the door for collaboration. When users can directly vote on the issue they face, they are incentivized to collaborate with other community members and reach a decision through discussion. This is why governance forums are the second-best social channel after Crypto Twitter.
  • More involved communities. Governance leads to more involved communities since users have both a reason and a method to actively steer a project’s path and direction.
  • Efficient development. Although developers do not altogether forego their part in the decision-making process, governance models make it easier for them to arrive at concrete answers and implement the changes deemed necessary by their community.

Disadvantages:

  • Selfishness. Just because one can vote does not mean that the person votes for the best outcome possible. Simply put, there will always be selfish actors that vote on decisions that only benefit themselves. Remember when the Maker community did not decide to reimburse their own community after the March flash crash liquidation?
  • Lack of accountability. Following the case above, it is clear that there will never be real accountability with democracy-based governance models. If a decision goes wrong, the community will always blame an invisible group that is not clearly defined. Users will always blame ‘the majority,’ and you will find no one revealing himself to be ‘the majority.’
  • Whales. Almost every governance protocol has that one whale that accumulates the project’s token. Investors often fear that at one point, the whale will, through sheer financial power, take over a majority of the tokens and singlehandedly create proposals and reach a selfish decision—a nightmare for blockchain democracy.

Final Word

Governance tokens represent the foundation block of all things decentralized. They are the central point of most DeFi projects nowadays, and without them, developers would not have the right to boast how decentralized and better their platform is compared to CEXs.

Like the Agora in ancient Greece, governance models are the main spot for political thought and discussion. Forums are always filled with new entrants and ideas that seek to better the project and increase its value. After all, what is the purpose of investing in a governance token if you wish to destroy or harm the platform?

But governance tokens are not without their faults. Malicious actors can still perform activities akin to 51% attacks by merely accumulating tokens. With enough financial power, a whale can disrupt the whole project and single-handedly create and approve decisions.

However, it is worth noting that it takes a long time to reach such a stage. Until then, users have the power to implement features that can prevent similar events and stop whales in their tracks.

About The Author:  

More Lessons in

A Beginner’s Guide to Decentralized Finance (DeFi)