How Does Governance Token Work?

A governance token is a type of crypto asset that empowers holders to take part in voting and other critical decision-making on a crypto platform. The sole aim of this token is to ensure holders have quality input in how a protocol is operated, thereby decentralizing the decision-making process.

In addition, with incentives, governance tokens encourage community members to participate in the activities on the platform actively. Apart from voting, governance token holders can take out loans, and make more profit via yield farming or staking the tokens. Ultimately, the general function of these tokens is to distribute power.

The efficacy of governance tokens is still a debatable topic in the industry, as the concept is relatively new. However, in this article, we will talk about the mechanism, advantages, and disadvantages of governance tokens.

How Do Governance Tokens Work?

Developers leverage governance tokens to create distributed governance in decentralized apps, decentralized finance protocols, and decentralized autonomous organizations. As a community member of a project, you would be rewarded a governance token when you significantly contribute to the growth and progress of the community or display your loyalty and commitment to the project. With this governance token given to you by the developers, you can actively participate in critical decision-making by voting and other project governance activities.

However, each decentralized project has peculiar regulations for using its governance tokens. For instance, some projects allow holders of governance tokens to take part in voting during specific and limited numbers of governance matters. However, others allow holders to vote for every governance activity on the platform. A popular example of a government token is the MakerDAO, which is based on Ethereum. It allows holders to vote on regulations, group members’ appointment fees, and every other government issue to improve transparency and stability.

Benefits of Governance Tokens

Governance tokens have their unique functions in the decentralized community; some of these benefits are listed below:

• Distributed Decision-Making: Governance tokens offer users the ability to partake in the decision-making protocol concerning the project’s regulations, upgrades, and other vital components. In other words, governance token makes sure the community members have a say in how the project is run, eliminating centralized authority.
• Unanimous Protocol Upgrades: In a decentralized community, any changes or upgrades that would be needed on the protocol would be done with all community members’ consent to maintain the core values of the protocol. This significant feat is achieved by community voting leveraging the governance tokens.
• Security and Trust: Involving community members in critical decision-making helps to put all hands on deck in evaluating any potential changes. This effectively identifies and solves any possible risks, thereby improving trust and security on the platform.
• Incentivizing Participation: Community members holding governance tokens are often incentivized to vote and perform other tasks in the community, which further boosts members’ engagement and participation.
• Token Economics:  Governance tokens are pivotal to the tokenomics of the crypto space as they serve as staking, DeFi apps collateral, and liquidity provision to help preserve the network.
• Resistance to Centralization: Allowing governance token holders to vote and take part in essential decisions helps to carry the community along in every activity and helps to resist monopolistic control and centralization in the protocol.

Risks Involved In Governance Tokens

Holding a governance token comes with its risks and challenges, which are listed below:

• Token Price fluctuations: like typical cryptocurrency assets, the price of governance tokens can be positively or negatively impacted by sentiments, news, or FUDs because they are also very volatile. Hence, without proper precautions, these tokens can lose their value.
• Governance Centralization: Sometimes, a few people who hold the large percentage of the governance tokens might take leadership roles in making vital decisions without carrying the whole community along. In other cases, low participation may result in some set of people calling the shots in the community. Either way, this can lead to partial or total centralization of a platform that is supposed to be fully decentralized.
• Security Vulnerabilities: malicious actors can target the governance process itself, which sometimes can be exposed to security risks like collusion or manipulation of votes, thereby compromising the probity of the protocol’s decision-making process. Consequently, these harmful changes can be made to the network.

Conclusion:

It is crucial for participants in governance token systems to carefully assess these risks, conduct thorough research, and consider their risk tolerance before getting involved. Additionally, active engagement and vigilance in the governance process can help mitigate some of these risks.