What are governance tokens

Many traditional organizations are centrally governed through a single body, such as a board of directors or a small group of individuals. For example, large companies typically have a board of directors with significant power. These directors can appoint or fire executives, decide on projects to invest in, and set the company's development strategy.

While traditional companies operate with a similar centralized model, governance tokens offer an alternative approach based on the principles of fairness, decentralization and transparency. This method is widely used in decentralized autonomous organizations (DAOs) and decentralized finance (DeFi). Typically, each token provides the right to one vote, which unites community members and contributes to the effective development of blockchain projects.

This provides them with the opportunity to participate in voting on issues related to the development and improvement of the project. Typically, voting is carried out using smart contracts, which ensures that the results are executed automatically.

MakerDAO, one of the first decentralized autonomous organizations based on Ethereum, has released the MKR governance token, which gives voting rights to holders. Maker Protocol, controlled by MKR holders, has developed a crypto-backed stablecoin called DAI. Each MKR token provides the owner with one vote, and solutions with the most votes are implemented in the project. Token holders vote on various issues, including appointing team members, adjusting commissions, and approving new rules. This mechanism ensures the stability, transparency and reliability of MakerDAO's DAI stablecoin.

Another example is a DeFi protocol called Compound, which provides the ability to lend and borrow cryptocurrency. To make key decisions on the Compound network, the COMP governance token has been released. The distribution of COMP tokens is proportional to user activity on the network: the more a user borrows and borrows on Compound, the more COMP tokens he receives.

Similar to MakerDAO, each COMP token is worth one vote. Users also have the ability to delegate their assets to validators. It is important to note that in 2020, Compound took a step towards full decentralization by relinquishing control of the network admin key, meaning that the project is now entirely managed by token holders without any centralized means of governance.

Each project sets its own unique rules for using governance tokens. Depending on the distribution model, these tokens can be distributed among founders, investors and users. Some governance tokens only allow voting on a limited set of governance issues, while others allow voting on virtually all issues. Additionally, some governance tokens may provide dividends, while others do not.

Governance tokens have a number of significant advantages. They help prevent conflicts of interest, which often arise with centralized management. Governance tokens play a key role in decentralization by transferring power to the wider community and taking into account the interests of users and the organization.

Another important benefit of governance tokens is creating active and loyal communities. Each token owner is motivated to participate in voting and implement improvements to the project. A model where each token is equal to one vote creates the basis for fairer decisions. Each token owner has the opportunity to propose changes, and the results and voting process are open to public review, which reduces the likelihood of manipulation and deception.

The “whale problem” is one of the main problems associated with governance tokens. Whales are users who hold large amounts of a particular cryptocurrency. If large whales own a significant share of a governance token in a project, they can have a significant influence on the voting results. To prevent such a situation, projects need to ensure a decentralized and even distribution of tokens.

However, even with a fair distribution of tokens, there is no guarantee that the decisions of the majority will contribute to the well-being of the project. Electoral systems based on the principle of "one person, one vote" have existed for a long time, and their effectiveness is questionable. There have been cases where governance token holders have voted in favor of developers and large investors, but this could have a negative impact on the interests of the wider community.

Governance tokens are a significant innovation in the cryptocurrency world and will certainly see widespread use in many sectors, especially in the context of the decentralized Web3 Internet. As DeFi and DAOs grow, this governance model may be adopted by other industries such as the gaming industry.

Governance tokens will continue to evolve and find solutions to emerging problems. Perhaps in the future new mechanisms will be developed to combat the whale problem or improve the voting process. New methods of voting delegation may also emerge. With many innovations emerging, the crypto space will continue to become more complex.

Another important aspect that may affect the future of governance tokens is possible changes in legislation. Some states consider tokens as securities and impose strict restrictions, which can significantly affect the work of projects in this area.