Governance tokens play an important role in the Web3 ecosystem. Namely, their holders use them to vote on the direction in which a certain DeFi project will take place. Yet, that is not their only purpose.

Keep on reading to find out how governance tokens work, what are they used for, and what are their main pros and cons. There’s also a section where we’ll explain what differentiates them from utility tokens.

Learn in This Article

  • Governance token definiton
  • How it works
  • Advantages and disadvantages of governance tokens
  • Examples of governance tokens
  • Governance tokens and utility tokens

What Is a Governance Token?

A governance token is a digital currency used to manage protocols built on blockchain. In this way, Web3 developers share control over their projects with token holders. This means that token holders will get to decide how a specific project will develop. For example, they’ll be able to vote on the distribution of rewards and fees, as well as on new features.

Governance tokens are also the basis for setting up decentralized governance in DAOs, dApps, and DeFi projects. Investors who want to be part of a certain crypto project can get their tokens via presales or airdrops. They can also be earned by staking.

Since governance tokens are a new concept, opinions about their effectiveness are divided. While some believe that they will contribute to decentralization, others think that their implementation could lead to a concentration of power.

How Do Governance Tokens Work?

Token holders can influence the way a certain project will develop through voting. One token represents one vote — more votes means greater influence over the project. Keep in mind that each project will implement different rules on the use and distribution of its tokens.

To be able to vote, token owners will have to buy or earn a certain number of tokens and store them in one of the top cryptocurrency wallets. Each project will have its website with a list of active proposals.

Certain proposals may come with minimum requirements, depending on the project. Voting is conducted through smart contracts to prevent third parties from interfering.

After the voting, the project developers use the consensus mechanism to decide which changes should be executed. All proposals must be approved by at least 51% of token holders to be accepted.

Project developers can also use alternative voting systems. These systems will not be based on the number of tokens but on the engagement of their holders.

What Are They Used For?

Governance tokens can be used for on-chain and off-chain voting. On-chain activities refer to voting on proposals that are directly related to the project. For example, you can vote on development updates or smart contract revisions.

On the other hand, off-chain activities are associated with things that happen outside the project, such as discussions on online forums. Moreover, token holders can use their tokens for staking, yield farming, and taking out loans. For example, you can deposit your tokens into a liquidity pool to earn rewards.

Other use cases of governance tokens include:

  • Token holders have a say on the allocation of resources — they decide how the pool funds will be used and where
  • Active token holders can get access to exclusive features that are not available to other members, such as lower fees and access to specific events
  • Token holders can delegate their tokens to their representatives
  • They can update the user interface and user experience on dApps
  • Increase or decrease the interest rate on crypto lending platforms

Advantages of Governance Tokens

The main advantages of governance tokens include:

Decentralization

The only way dApps can be managed is through governance tokens. Without them, no one would have control over smart contracts.

The Right to Vote

Government tokens enable their holders to vote on changes within crypto projects. This means they are basically shaping the project’s ecosystem. Moreover, token holders can bring their proposals to the vote. The voting process is conducted via smart contracts, so there is no interference from a third party.

Increasing the Value of the Project

Government tokens allow their holders to participate in decision-making within the project, instead of leaving that task to the project developers. In this way, everyone becomes the owner of the project. This sentiment can increase people’s commitment to the project, thereby increasing its overall value.

Disadvantages of Governance Tokens

Governance tokens come with certain disadvantages, of which the following are the most common:

Voting Issues

Since everyone has the right to vote, there is a chance that certain people will vote in their interest. This may not always be the best for the future of the project.

Accumulating Tokens

As we mentioned before, more tokens mean more voting power. This can lead to the accumulation of tokens by one person, which would create an imbalance since one person would practically own the entire project.

Governance Tokens Examples

The most popular governance tokens are: 

  • MKR — a native token of the Maker Protocol 
  • COMP — a native token of the Compound protocol 
  • UNI — a native token of Uniswap, a decentralized exchange
  • AAVE — a native token of Aave, a decentralized lending platform
  • YFI — a native token of Yearn.finance, a decentralized DeFi platform

Difference Between Governance Tokens and Utility Tokens 

The main difference between utility and government tokens is that the former are intended for a specific purpose, such as paying a fee or accessing a specific service. In contrast, government tokens allow the holders to participate in the management of crypto projects. 

Furthermore, utility tokens have no management power, and they can be used only as a means of exchange. On the other hand, government tokens can be used for several purposes, such as staking and taking loans.

Here are some other factors that distinguish them:

Feature

Governance Tokens

Utility Tokens

Function

Used for voting within a decentralized organization

Used for payments within a decentralized platform

Value

Based on the value of the project

Based on its demand

Supply

Limited or fixed

Unlimited or fixed

Price

Based on the project, can be volatile

Less volatile if it’s linked to a specific asset

Liquidity

Low liquidity

High liquidity

Conclusion 

Government tokens give investors a chance to vote on the development of projects. At the same time, they can help developers create successful projects based on a large community. In addition, government token holders can receive extra benefits, such as access to exclusive features and lower fees.

The value of government tokens will grow if the project is successful, which makes them a good long-term investment. However, their biggest disadvantage is that their voting value depends on the amount of accumulated tokens. This means that people who own a large number of tokens would have more influence over the project and its development.