A governance token gives holders the authority to vote on proposed changes to smart contracts within specific protocols. This allows token holders to express their opinions and influence the changes made to the protocol's operations. Cryptocurrency projects operating in a decentralized autonomous organization (DAO) issue governance tokens, and owning a governance token grants automatic membership in the DAO. ^[1][2]

Overview

A governance token is a digital currency that permits holders to engage in on-chain governance processes for a cryptocurrency project. It is an essential element of the decentralized finance (DeFi) protocol, enabling the effectiveness of decentralization. The governance token influences how decentralized applications (dApps) reach agreements by enabling token holders to propose new features for a project and make changes to its governance system based on their voting powers. Governance tokens play a vital role as decision-making tools in DAOs, which denote community-owned blockchain and cryptocurrency initiatives. ^[1][2][3][4]

Governance tokens have their origins in DAOs, which are essentially communities of individuals following defined rules to achieve common objectives. These DAOs operate without a central governing body, ensuring that no single individual has full control or ownership over the entire organization. DAOs employ smart contracts to execute specific actions when certain conditions are met while providing a trustless environment for transactions and information sharing. In addition, DAOs can establish organizations without any hierarchical structure, allowing members to hold equal control over the organization through governance tokens. ^[5]

A governance token is provided to users to symbolize their stake in the DAO, and participants are mandated to invest their funds in return for voting privileges, ensuring their genuine involvement and the success of the DAO. Typically, under this arrangement, those who invest larger amounts possess more substantial voting influence compared to those with smaller investments. ^[6] For instance, someone with 1,000 governance tokens holds double the voting power of a holder with 500 tokens, although each DAO may have slightly different governance protocols. ^[4]

While the governance token is mainly used for voting on various governance proposals, it can also be used in a number of other ways:

• Yield farming
• Staking and lockups
• Lending and borrowing
• Cash flow from fees.^[7]

Governance Models

Decentralized governance operates through two distinct models: on-chain governance and off-chain governance. ^[4]

On-chain Governance

The process of allocating control among stakeholders is referred to as on-chain governance. On-chain governance involves decentralized decision-making methods applied directly to a blockchain. In this system, rules are encoded directly into the protocol, ensuring that every decision is instantly translated into executable code. Terra is an example of a network that uses the governance token LUNA to allow holders to engage in votes regarding network policies. ^[4][6]

Off-chain Governance

Off-chain governance refers to the decision-making processes happening at a social level before developers incorporate them into the protocol. Ethereum and Bitcoin are typical examples that predominantly rely on off-chain governance. Ethereum acquires improvement protocols through EIPs (Ethereum Improvement Proposals), community calls, and developer meetings, and Bitcoin developers share their improvement proposals via mailing lists, forums, and BIPs (Bitcoin Improvement Proposals). In this system of governance, miners hold responsibility for determining the adoption of proposals. However, users retain the option to respond by selling their tokens or migrating to an alternative protocol. ^[4]

Governance Tokens Value

Governance tokens are important in community-owned projects for a variety of reasons: decentralization, ecosystem growth, easy community management, incentivization and marketing, and economic-political value. ^[2]

Decentralization

Governance tokens make it possible for DAOs to establish a genuinely decentralized administrative system without requiring significant technological modifications to the core blockchain, smart contract, or dApp. The decentralization introduced by governance tokens hinges on equitable distribution and the voting process, and that's why many new DAOs opt for distributing governance tokens freely through community airdrops, ensuring a fair and inclusive system. ^[2]

Ecosystem Growth

Governance tokens have the potential to shape the direction of a cryptocurrency and blockchain project, including mainstream DAOs. A functional DAO is a compelling draw for individuals seeking engagement in an ecosystem where their opinions hold significance. In addition, an active DAO can translate into a valuable governance token as its worth increases with the DAO's significance. This aspect is particularly attractive to traders and individuals with a long-term perspective, ultimately accelerating the growth of the project's ecosystem. ^[2]

Easy Community Management

Reaching consensus on centralized platforms like Telegram and Discord can be challenging, while DAO portals and governance tokens greatly alleviate this issue, as the blockchain's immutability ensures that token ownership remains secure and unalterable. Members' voting power is determined by the tokens they hold and those delegated to them, a feature that cannot be tampered with. ^[2]

Members can vote at their convenience, requiring minimal moderation from the project, as the voting application manages most of the procedure. This streamlined process yields a final and comparatively more reliable outcome, saving valuable time and resources, particularly for large communities. ^[2]

Examples

There are various governance tokens obtainable, and a few examples include: 0x (ZRX), Aave (AAVE), and Aragon (ANT). ^[9]

0x (ZRX)

0x is an infrastructure protocol that facilitates the seamless trading of ERC-20 tokens and diverse assets across multiple blockchains, including Ethereum, without relying on centralized intermediaries. The protocol's governance token, ZRX, operates as an ERC-20 token, granting holders direct influence over protocol modifications and the community Treasury. ZRX also enables participation in staking to earn liquidity rewards. Furthermore, ZRX serves as 0x's utility token, rewarding relayers with trading fees for hosting an order book. ^[10][11][12]

Aave (AAVE)

Aave operates as a fully decentralized, community-governed protocol led by AAVE token holders. These token holders participate collectively in discussions, proposals, and voting processes for protocol upgrades. Specifically within the Ethereum network, AAVE token-holders have the option to vote directly on new proposals or delegate their voting authority to a preferred address. ^[13][14]

Aragon (ANT)

Aragon serves as a platform aimed at assisting developers and communities in creating and managing decentralized autonomous organizations (DAOs). The Aragon Network Token (ANT) functions as the platform's native token, predominantly utilized for governing the Aragon Network. ANT holders can actively participate in Aragon governance by voting on proposed initiatives. Previously, ANT was utilized for staking in Aragon Court but has since been discontinued. At present, ANT is involved in supporting community polls accessible via the Aragon Voice App, and every token holder has the ability to vote on these proposals and take part in the community's decision-making process. In Aragon, the number of tokens directly corresponds to voting power; a user holding 500 tokens carries 500 times more voting power than someone with just 1 token. ^[15][16]