In the blockchain industry, there is a cryptocurrency that gives its holders the right to vote on how a project should be run. This crypto is known as a governance token. The idea is to decentralize the process of making decisions.
Since holders of governance tokens invest heavily in a project, they usually strive to ensure that the project is successful in order to avoid losing their funds. They can propose and approve changes that they believe are best for the project. For example, holders can propose modifying the user interface or the project’s code and recommend a new reward distribution system.
Besides allowing its holders to vote, governance tokens have other use cases in decentralized finance. Holders can stake them to earn yield or use them as collateral to secure a loan.
Governance tokens have been subject to a strong debate in recent months. Some crypto users argue that these tokens may cause the centralization of power among a few holders, while others believe that they are the key drivers of true decentralization.
How Do Governance Tokens Work?
Governance tokens are the pillar of DAOs (decentralized autonomous organizations). That means instead of giving decision-making power to a particular small group of individuals, it is distributed to everyone involved in the project.
Note that the voting process is done via smart contracts; therefore, the outcome is implemented automatically.
Each DAO has set out its own governance rules. For example, some have policies that limit the ability of some governance token holders to vote on certain proposals depending on the number of tokens held.
One of the first DAOs to issue governance tokens is MakerDAO. The MKR token allows its holders to govern this Ethereum-based project. Each MKR represents one vote. Among the issues that holders of this token vote on include rules, team member appointments, and fees. The goal is to ensure that MakerDAO is managed efficiently and transparently.
Lending protocol, Compound, is another crypto project that has a governance token. It is known as COMP. Holders of this token receive more based on how active they are involved in the Compound protocol. That is to say, whoever borrows or lends more regularly gets rewarded with COMP. Each token is equal to one vote. Unlike MakerDAO, Compound allows COMP holders to delegate their tokens to others so they can vote on their behalf.
What’s the Difference Between Utility and Governance tokens?
Utility tokens are cryptocurrencies created to serve a specific purpose, like facilitating fee payment. On the other hand, governance tokens give holders the ability to influence a project’s direction.
BNB is one of the popular utility tokens in the market. Created by crypto exchange Binance, BNB is used to pay trading fees on the platform and entrance fees for programs such as Binance Launchpad. Additionally, the token is used to collect gas fees on the Binance Smart Chain.
The key difference between utility and governance tokens is that the former lacks governance power but has more use cases than the latter.
What are the Pros and Cons of Governance Tokens?
Pros
One of the benefits of governance tokens is that they enable decentralization, which is the main Web3 principle. There are no other cryptocurrencies that allow their holders to govern projects other than governance tokens.
Another governance token advantage is that they reward users for participating in a particular project, like in the case of Compound, as mentioned earlier.
The third benefit of governance tokens is that they promote efficient development as project developers only create features that the users want, unlike traditional organizations where developers spend significant resources to build features that users may never use.
Cons
The biggest disadvantage of governance tokens is that they are complex for many to understand because they’re a relatively new concept. That said, some users might be left out of the decision-making process, letting others govern the project on their behalf.
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