What Are Governance Tokens and How Do They Work?

Governance tokens let you vote on how crypto projects operate. You buy tokens, you get voting rights. Simple as that.

These tokens appeared when DeFi projects wanted to decentralize control. Instead of having founders make all decisions, they gave communities voting power. Now token holders decide on protocol changes, fee structures, and treasury spending.

The Mechanics Behind Governance Voting

Most governance happens through dedicated portals or platforms like Snapshot. You connect your wallet, browse active proposals, and cast votes. The whole process takes minutes.

Voting periods typically run 3-7 days. Projects set minimum participation thresholds – usually requiring at least 10-20% of tokens to participate. If a proposal passes, smart contracts execute the changes automatically.

Gas fees can make voting expensive on Ethereum. During network congestion in 2021, single votes cost $100 or more. Many projects moved to Layer 2 solutions or alternative chains to reduce costs. 

This transition to less expensive networks has been advantageous to different areas, including crypto casinos, which have adopted multiple tokens to make deposits and withdrawals. Platforms like Solana gambling have gained popularity because of their network’s fast transaction speeds and minimal fees. They simplify the involvement of users in the processes of playing and governance without having to fear spending too much money.

Major Players in Governance

Uniswap distributed UNI tokens to anyone who used the platform before September 2020. This massive airdrop created one of crypto’s largest governance communities. UNI holders vote on fee switches, grant distributions, and protocol upgrades.

Compound pioneered DeFi governance with COMP tokens. Holders decide which assets get added to lending markets and adjust interest rate parameters. The protocol automatically implements approved changes.

MakerDAO runs the most complex governance system in DeFi. MKR holders vote on everything from stability fees to emergency shutdowns. Their decisions directly impact DAI’s dollar peg.

Aave lets AAVE holders vote on new market parameters and safety features. Token holders also serve as backstop insurance – their tokens can be slashed if the protocol faces losses.

How to Get Governance Tokens

You can earn tokens by using protocols. Many DeFi platforms reward liquidity providers, borrowers, and traders with governance tokens. The longer you participate, the more tokens you accumulate.

Airdrops represent another major distribution method. Projects often reward early users with free tokens. Optimism gave tokens to users who bridged to their network. ENS distributed tokens to domain holders.

Direct purchases work too through crypto wallets. The majority of governance tokens are listed on large exchanges. The prices change with the success of the underlying protocol and future actions of governance.

Real-World Impact

Governance votes create measurable outcomes. Uniswap’s fee switch vote generated significant debate about value accrual to token holders. The community ultimately decided against turning on fees for most pools.

MakerDAO holders approved adding USDC as collateral for DAI minting. This decision helped DAI maintain its peg during market volatility but sparked controversy about centralization risks. The move proved crucial during Terra’s collapse when DAI needed stable backing.

Compound faced a major governance attack in 2022. A whale had earned sufficient tokens of the COMP to get a proposal through that would have emptied the treasury. The people united to stop the evil initiative, and it showed the weak points and strong points of decentralized governance.

Problems with Token Governance

Whale dominance plagues most governance systems. Large token holders can outvote smaller participants, creating an oligarchy instead of a democracy. Some protocols try to address this with delegation or quadratic voting.

Voter apathy is widespread. Most token holders never participate in governance. Typical participation rates hover around 5-15% of the total supply. This leaves decisions to a small, active minority who may not represent broader community interests.

Technical complexity barriers exclude many participants. Understanding protocol changes requires deep knowledge that most casual holders lack. Proposals often involve code changes or economic parameters that seem foreign to average users, leading to uninformed voting or complete abstention.

Token Economics and Incentives

Many governance tokens struggle with value accrual. Voting rights alone don’t generate cash flows or provide clear investment returns. This creates a disconnect between token price and governance participation.

Some projects experiment with value capture mechanisms. Fee sharing, buyback programs, and staking rewards try to align the token price with protocol success. Results vary widely across different approaches. The more rewards and voting power a token holder wants, the longer they have to lock their tokens in the Curve’s vote-escrowed model, creating scarcity and demand.

Meanwhile, trading fees of protocols such as Balancer are paid out to token holders, providing governance tokens with real economic utility rather than being a mere voting mechanism.

The Road Ahead

Progressive decentralization is becoming the standard approach. Projects launch with founder control, then gradually transfer power to token holders as systems mature. This balances early execution speed with long-term decentralization.

New governance mechanisms continue to emerge. Conviction voting, futarchy, and reputation systems aim to improve on simple token voting. These experiments might solve current participation and whale problems.

Governance tokens represent one of crypto’s most ambitious experiments – creating internet-native democratic institutions. Despite current limitations, they’ve already enabled coordination at unprecedented scales.