What is a governance token – and why does it matter?

Read 6 min
What is a governance token - and why does it matter
Key Takeaways:
— Governance is the way systems are controlled. We tend to think of it as the top-down approach we see in governments and corporations.

— Decentralized protocols show us there’s a way for truly democratic governance: The community has the right to vote and the votes drive changes democratically. 

— Off-chain governance is an informal approach to governing a blockchain network where decisions are discussed on and off the network and changes are implemented on the blockchain. This leads to a skew of governing authority towards devs, miners, and key stakeholders.

— On-chain governance is where the community votes on all decisions for the blockchain and the code executes the changes. Governance tokens are the key to this approach.

— Governance tokens offer the holders the voting rights to the network and the result is a truly community-driven system that encourages active participation.

Governance tokens are an incredibly important part of the crypto ecosystem, and are set to become more prominent as things evolve and mature. Here, we explain exactly how they work.

Governance /n/ “The system by which parties are directed and controlled.”

When we hear “governance” we typically think of a top-down approach, kind of like a government or a corporate entity. Someone is leading the structure and people follow the instructions. It’s the traditional approach to governing a body or collective and it’s kind of what we’re used to.

Top-down Governance

With traditional governance, there’s typically a pyramid of power and those overseeing have control over what happens. Below the decision-makers, there is a team to execute new developments.

And there are good reasons for using this structure. Largely, those come down to efficiency: with large communities, taking into account every point of view is difficult, both to organize and to execute. This is why we tend instead to elect just a few people to represent us, streamlining the process and enabling decisions to be made efficiently. 

But what about when those decision-makers aren’t elected?

When power is accumulated in the hands of a chosen few without necessarily being inclusive, the rest of the community are likely to feel they don’t have a say, and it also means projects are not representative of the people making them successful. The result? A community that’s less engaged with the project, and a project that reflects the views of only a few interested and powerful parties. Sounds a bit centralized.

What if governance itself could be decentralized? 

Blockchain Flips the Script on Governance

Blockchain set the stage for the decentralization of the financial system. Whereas previously, banks, governments and firms controlled our access to financial networks, the public infrastructure offered by blockchain allowed individuals to bypass those gatekeepers, and have access to a financial system where no one person or entity is in control. 

But when it comes to how the entities within that system are governed – we’re talking individual blockchains and projects – and the decision-making process behind their protocol, you might be surprised to learn that power is still pretty centralized. Let’s take a look at the different governance systems in use, and recent developments that are changing the possibilities for users and projects themselves.

Blockchain Governance Structures

Off-chain governance

This informal approach to governance mixes on-chain execution with off-chain decision-making processes.

With off-chain governance, decisions are made away from the blockchain – that’s to say, decisions are discussed at conferences and via written proposals, then executed on the blockchain in a separate process. Instead of true decentralization, off-chain governance sees key stakeholders (the lead developer team or significant miners) vying for control via influence and strategy (sort of like politics). 

The result? A system that is once again centered around an influential few. Let’s take a quick look at two of the top-dog cryptocurrencies who both use an off-chain governance system.

Bitcoin 

That’s right, the leading cryptocurrency – the protocol that lit the world up with the potential for decentralization – relies on off-chain governance. 

With Bitcoin, all major modifications suggested to the network are discussed off-chain. This is to say that big decisions are made at conferences and via messages by important parties, such as the core development team, miners and to some extent the end-user community. So owning BTC might give you a voice in the conversations, but ultimately you have no proper voting rights – development is proposed and decided centrally, and ultimately the activation of those new ideas is undertaken by the network nodes.

Ethereum 

Ethereum’s governance model is pretty similar to Bitcoin’s. There’s a core dev team (led by Vitalik Buterin) and any changes or modifications to the network are addressed both publicly and in private discussion. Users of the protocol get a say, but they don’t quite get the sway that might influence change.

What happens here is that the control is centralized around a few stakeholders and a few influential people get a genuine say in where the protocol can go. In other words, simply holding some ETH does not give you a say in how the network is run.

On-chain governance

If off-chain governance sees big decisions discussed informally by a core few, on-chain governance moves the entire process onto the blockchain itself and gives all stakeholders a voice.

Here, proposals are accepted or rejected via governance tokens (we’ll talk about that below) which allow holders to cast a vote on key decisions and have it weighted to reflect their stake in the project.

The key difference between off-chain and on-chain governance is in how decisions are made and by who. With off-chain governance, very few parties really get a say in the process – by the time proposals reach the blockchain, they have already been defined and shaped by a few core voices, and even then, the final adoption of those proposals rests with the nodes, rather than the stakeholders in the currency itself. 

With on-chain governance, all changes are coordinated on the blockchain network and are approved or rejected proportionately by anyone who holds a governance token.

What is a governance token?

If blockchain allowed the whole system to become decentralized, then governance tokens take the movement a step further by enabling the entities within that system to decentralize themselves as well.

Simply put, governance tokens are crypto tokens that interact with the smart contract of a blockchain to grant an owner voting powers for the project. They’re like a little voting chip issued to members involved in the project to accept or reject proposed changes. This means that anyone with a governance token has the power to directly be involved in where a protocol might go. 

Every token offers the owner a voice in the ecosystem, meaning devs, big wigs and big miners don’t make the decisions in a silo. 

The beauty in a governance token is that it allows projects to become fully decentralized and autonomous, forming and galvanizing a community by distributing control to the users in an organized way – from here, hierarchy is no longer actually needed. 

This has already created ripples in how we organize and what we expect. The emerging ecosystem of DAOs for example has been enabled by governance tokens, permitting token holders to form a real community and be heard within that community. 

This means that all sorts of DAOs, from creative projects to automated market maker (AMM) DAOs, investment DAOs, and metaverses have been established by the concept of a token that empowers the community to run the project and dictate its future. 

Governance Tokens in Action – Key Examples from Across the Sphere

To get a better picture of exactly what sort of projects are utilizing governance tokens, and how, let’s take a look at some recent examples, and what they meant for their projects and community.

$YFI, Yearn.finance’s fairest launch ever

Decentralization exists on a spectrum, and it makes sense to begin with the project pushing the limits of that spectrum. YFI is the token behind Yearn.finance, a project that was launched by a guy called Andre Cronje. His decision as the lead dev of the project was to create a token that would hand over the reins of the project entirely to the community and transform it into a ready to go, self-sufficient DAO  – in other words, Kronje himself did not keep any of the token, or its associated powers.

The launch of the project was a big deal and it’s considered one of the deepest dives into decentralization we’ve seen so far. It’s a bit of an experiment in the space, as it pushed the boundaries of how extreme decentralization could go, so keep watching YFI for insight about the future of decentralized communities.

Polkadot’s Crypto Democracy

People are people, and governing a blockchain comes with many of the same problems as real-life governments: one common bone of contention is low voter turn-out, which can make processes slow and unrepresentative. Polkadot – the layer-two blockchain seeking to make all networks interoperable – overcomes this with a formalized system, where Council Members can be voted on by holders of DOT to represent their interests, sort of like a member of parliament.

Polkadot not only embraces on-chain governance but also gave careful consideration to how its voting processes would interact with the people behind the tokens, to ensure the long-term success of the project. We might expect to see this more often as the blockchain ecosystem expands and matures.

Ethereum Name Service

One interesting trend to emerge from the use of governance tokens is incentivization of support for early-stage projects. Ethereum Name Service (ENS) adopters saw a MASSIVE reward with a huge airdrop of governance tokens in late 2020 and it caused a major stir in the space. The price of the project’s native token ($ENS) shot up and the early adopters saw an immediate reward for their initial support, which caused a huge buzz in the DeFi space and left many users wondering which projects would be next to do the same. 

The drop came with a bit of a caveat: To claim the tokens, users needed to vote on four of the articles of the protocol’s constitution first. It’s a case of active participation generating active rewards – representing the concept of governance token rather neatly.

Decentraland DAO

The metaverse promises to offer users hyper-realistic online societies that mimic real life, but offer greater potential for global collaboration, creativity and global self-governance. So it stands to reason that governance tokens are playing a big role in organizing the voices within that system. 

Decentraland, one of the biggest social metaverses in the space, is a DAO run by holders of the native tokens MANA, who can use it to vote on decisions and proposals about the Decentraland ecosystem and its future; these include whether certain locations should be points of interest for users to visit, scaling solutions, which members should be hired as DAO facilitators, the banning of some addresses from chatting, and a whole number of things that shape the future of the metaverse and where it goes. 

All of this can be undertaken by a community that is physically scattered but united around the management of Decentraland.

How to get governance tokens

There’s little room for doubt that these tokens will change our expectations – now, instead of simply wanting financial rewards from the projects we’ve bought into, users are coming to expect their loyalty to be rewarded with a stake in the project’s future. 

As we’ve learned from some recent drops (ENS we’re lookin’ at you), we can’t always predict when a project will launch its own governance token, or how the receiving wallets will be defined. But there are a few places you can look to gain a little insight about whether a project plans to launch its own governance tokens or has plans to become a DAO in future. This means looking at the project’s road map, chatting with active members of the project’s Discord community, reading the project’s white paper or having a look at its token details on EtherScan.

It takes a little bit of technical digging, but can often yield some good alpha about if there’s a drop coming in the future.

Governance tokens – value, power and responsibility

The distribution of power via governance tokens means that the fate of a project rests in the hands of its community.

Read that again. Yes, it is a bit scary. And that’s OK.

These tokens are not just about power – they confer a pretty big responsibility too. How a project performs relates directly to how we, the community, have managed it, and with decentralized governance still nascent, we’re yet to see where that will take the blockchain environment as a whole. But with DAOs emerging to rival traditional companies in nearly every sector, the metaverse on the ascent and DeFi continuing to offer users fairer access to finance via decentralized protocols, it seems this is the start of something pretty significant, not just in terms of technology, but in terms of what we consider a community to be.

So stay informed, talk to the projects that interest you and make sure you do you own research – the reward is having a voice where you never had one before.

Knowledge is power.

Interested in governance structures? You should be! They’re changing everything, and could benefit you. Here, School of Block explains DAOs. Enjoy!


Stay in touch

Announcements can be found in our blog. Press contact:
[email protected]