A governance token is a cryptocurrency that gives its holders a right to vote on proposed changes to a blockchain network. This innovation is seen as a necessary step toward keeping certain crypto projects, particularly those within the decentralized finance (DeFi) ecosystem, decentralized. The idea is that rather than a single person or group controlling the direction of a platform, a community of users can influence decisions in a process known as governance.
While not unique to DeFi, governance tokens have become a key attribute of the DeFi ecosystem. Stick with us in this crypto guide to learn more about the question “what is a governance token.”
What Are Governance Tokens Used For?
Governance tokens give users of a particular blockchain protocol certain rights — such as the right to vote on proposed changes to the network. This could include granting token holders the ability to create new proposals or to spend tokens in an attempt to alter an existing proposal.
Other examples of uses for governance tokens might include:
• Voting for changes to a network’s fee structure
• Implementing changes to a project’s user-interface
• Changing a network’s reward structure
• Revising the amount of funding that developers receive
Governance tokens can have other functions in addition to granting voting rights to holders. Most DeFi tokens have governance features built into them, and most of them can also be used for things like staking crypto and yield farming.
Examples of Governance Tokens
As mentioned, most governance tokens are involved in the DeFi space in one way or another. Community governance is a key function that helps to keep DeFi decentralized. Most DeFi protocols run on the Ethereum blockchain.
Here are some examples of popular governance tokens.
Compound (COMP) is an ERC-20 utility token running on Ethereum. The protocol is a DeFi lending/borrowing platform. COMP holders have a chance to vote for changes to the network via the compound governance dashboard.
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Yearn.finance (YFI) is also a DeFi protocol hosted on Ethereum that offers lending, borrowing, and trading services. The platform has different products like Earn, Zap, Vaults, and APY. Users can earn YFI tokens by locking up crypto funds in smart contracts that run on Curve and Balance (other DeFi trading platforms). This allows users to participate in what’s known as yield farming.
Yield farming is the act of locking up funds in a DeFi protocol to earn interest. The more value that users lock up, the more tokens they earn as rewards.
Based on Ethereum, Maker is responsible for creating the DAI stablecoin. MKR holders can vote on new proposed changes to the Maker DAO network inside the Maker Voting Dashboard. DAI has been praised for being one of the few stablecoins that are intended to be decentralized. It has also been integrated into some games, wallets, and DeFi apps.
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Synthetix Network Token (SNX)
Synthetix is a decentralized exchange (DEX) for synthetic assets. Also known as “synths,” these are tokens that are designed to mirror the price of a real-world asset. Whether it be bonds, stocks, commodities, or fiat currencies, users can trade synths in an effort to gain exposure to the price of a particular asset. This can be beneficial for those who might not have access to traditional capital markets.
SNX, the native token of the Synthetix Network, functions like a stablecoin in that it is pegged to an external asset at a one-to-one ratio. However, rather than being tied to a single currency, Synthetix allows users to mint a synthetic asset that will be backed by SNX. SNX holders can also influence the direction of the platform going forward.
Aave is a DeFi platform for borrowing, lending, and earning interest on crypto. Much like its peers, Aave runs on a series of smart contracts that manage the platform’s financial operations. Users can borrow funds and pay interest, or lock up crypto to earn interest. AAVE is the network’s native token, and it gives holders a say in the platform’s future development.
Governance Token vs Utility Token
When trying to answer the question “what is a governance token,” it’s useful to think of it as an improved type of utility token. Utility tokens usually have a single specific use case only.
For example, Binance coin (BNB) is used to give discounts on trading fees to traders who use the Binance crypto exchange. Holders may get to vote on which tokens they’d like to see listed on the exchange, but that’s very different from voting on a fundamental change to the protocol of a specific blockchain; which is a function of a governance token.
A governance token offers the best of both types of tokens. It can be used for various purposes, while also giving a share of network governance to those who hold it. In fact, many governance tokens adhere to the ERC-20 token standard, which is a set of criteria that utility tokens minted on the Ethereum network must abide by.
Governance Tokens: Potential Advantages and Disadvantages
While the idea of a governance token may sound almost perfect in theory, in practice governance tokens have their advantages and disadvantages.
• Decentralization. Governance tokens allow developers to keep projects decentralized. Without this type of governance structure in place, DeFi platforms would be only collections of smart contracts that no one could control.
• More effective and inclusive development processes. Developers can arrive at conclusions and implement changes after receiving guidance from the community, instead of needing to figure out everything on their own.
• Community involvement. Governance gives a project’s community a reason to come together to help improve the platform.
• Potential for a takeover. Individuals or groups with large amounts of capital can sometimes acquire enough governance tokens to make unilateral decisions affecting the network. This can defeat the whole purpose of a governance token, which is to keep decision-making decentralized and democratic.
• Selfish decisions. Just because people have the ability to vote doesn’t mean they will always act in the best interest of their own community. A real-time example: In 2020, Maker experienced a flash crash that caused many of its investors to lose large sums of cash. Initially, the Maker community — represented by current holders of MKR governance tokens — voted to reimburse investors. Six months later, the community rescinded the vote; none of Maker’s investors could reclaim any of the money they lost.
• No real accountability. Ultimately, there’s no legitimate accountability when it comes to democratic crypto governance. If a decision is deemed to be wrong or appears to go against the best interest of many users, there’s no clear person or party to blame or hold accountable.
A governance token is not a unique type of token. Rather, a governance token may be any token that gives its holder a share of influence over how a crypto network is governed. In addition to their use in the decentralized finance sector, governance tokens may also be utilized on social media platforms that are decentralized.
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