What Governance Tokens Are And How They Work

With the rapid growth in technology and increasing risks, the cryptocurrency sector is unlocking new models for organisation and ownership. One of these models is decentralized autonomous organization (DAO), under which each participant or owner has a stake and commensurate rights.

This stake is often represented by “governance tokens”, which are issued to each stakeholder. Usually, the tokens are proportionate to the size of the stake and empower the holders. Decentraland, one of the biggest social metaverses in the space, is a DAO run by holders of the native token MANA. The holders can vote on decisions and proposals about the Decentraland ecosystem’s future as well as other detailed aspects.

Here's why governance tokens are important for DAO to work as decentralised entities.

Why Are Governance Tokens Crucial To DAO?

Decision-Making: In the decentralised crypto world, the process of a blockchain or protocol update is usually initiated by the core development team, and users holding governance tokens can vote on these proposals to decide whether to implement the update.

These tokens confer certain powers to their holders. They may include the authority to change the project’s protocol or vote on the network policy.

Besides its on-chain governance, Polkadot pays attention to its voting processes involving interacting with the people behind the tokens to ensure the project's long-term success. Holders of its token DOT can vote to represent their interests.

“A community can act like an enormous committee in this way. The powers of the governance tokens may include traditional management roles and the authority to change the project’s protocol. Users’ votes are weighted proportionally to the size of their holdings of a governance token,” says Johnny Lyu, CEO of KuCoin, a global crypto exchange.

Decentralisation: Governance tokens are a crucial part when it comes to distributing control of blockchain projects among the user communities.

These tokens incentivise communities by distributing control to users in an organised manner. Therefore, it ensures that each holder is involved in the governance of the protocol and avoids manipulation of the network by a small number of people.

In other words, they offer all the owners a voice in the ecosystem. “The emerging ecosystem of DAOs has been enabled by governance tokens, permitting token holders to form a real community and be heard within that community," says Lyu.

Experts believe that governance tokens allow projects to become fully decentralised and autonomous. For instance, YFI is the governance token for Yearn.Finance, the project launched by DeFi developer Andre Cronje. As the project’s lead developer, Cronje does not retain any tokens or associated powers, but leaves control of the project entirely to the community, making it a ready-to-use and self-sufficient DAO.

“Governance tokens are essential to decentralise the power of decision-making to a set of users who are seriously committed to the success of any blockchain project. The decision-making can influence the direction of the project, such as any new product innovations, partnerships to forge, budget spending decisions, etc.,” says Nischal Shetty, co-founder and CEO at WazirX.

Future of Governance Tokens

Governance tokens have enabled the emerging ecosystem of DAOs, allowing token holders to form a real community and be heard within that community. “This means that the concept of a token that empowers the community to run the project and dictate its future has given rise to a wide range of DAOs, from creative projects to automated market maker (AMM) DAOs, investment DAOs, and metaverses,” says Lyu.

However, Oriol Caudevilla, a fintech advisor and board director at the Global Impact FinTech Forum (GIFT), believes that even though the future of governance tokens will depend partially on external elements such as regulation and the actual growth of DAOs, these tokens will be an essential element in the future of decentralised and user-owned networks.

“With the rise of DAOs and metaverse, and with DeFi continuing to offer users access to finance via decentralised protocols, it seems that governance tokens are undoubtedly the start of something very significant,” says Caudevilla.

But the regulatory landscape may also have an effect. “The future of these tokens depends on the regulatory climate and the adoption of DAO operating models and DeFi,” says Darshan Bathija, CEO and co-founder of Vauld, a crypto exchange.

Experts also noted that governance tokens are not just about power but confer responsibility on the stakeholders. Further, how a project performs relates directly to how its community manages it.